Farm and Ranch Income Tax/Estate and Business Planning Seminar/Webinar, August 13, 2019 Materials

"Farm and Ranch Income Tax/Estate and Business Planning"

Washburn University School of Law Kansas St. University Dept. of Agricultural Economics WealthCounsel and Skyson Financial

Steamboat Springs, Colorado Farm Income Tax August 13, 2019 washburnlaw.edu/waltr

The Washburn Agricultural Law and Tax Report (WALTR) is authored by Roger For students and those involved in agriculture either as A. McEowen, the Kansas Farm Bureau Professor producers of commodities, consumers, or in the agricultural of Agricultural Law and Taxation at Washburn industry, WALTR helps you gain an ability to identify University School of Law. WALTR focuses on agricultural legal problems and become acquainted with the legal and tax issues that agricultural producers, basic legal framework surrounding agricultural issues and the agricultural businesses, and rural landowners face. tax concepts peculiar to agriculture. It will become evident that agricultural law and taxation is a very dynamic field that Some issues are encountered on a daily basis; others may arise has wide application to everyday situations. on a more cyclical basis. Many issues illustrate how the legal and tax systems in the United States uniquely treat agriculture WALTR is also designed to be a research tool for practitioners and the singular relationship between the farm family and the with agricultural-related clients. Many technical issues are farm firm. In addition, there are basic legal principles that addressed and practitioners can also find seminars to attend have wide application throughout the entire economy, and where the concepts discussed are more fully explored. In those principles are evident in the annotations, articles, and addition, media resources address agricultural law and taxation media resources. in action as it applies to current events impacting the sector.

Annotations Continuing Education The Washburn Agricultural Law and Tax Report covers Upcoming events include: annotations of court cases, IRS developments, and other • Ag Issues for Attorneys & CPAs technical rulings involving agricultural law and taxation. 8/23/2019: Richland County Justice Courtroom (Sidney, The annotations are broken down by topic area and are Montana) the most significant recent developments from the • Agribusiness Symposium courts, regulatory agencies, and the IRS so you can stay 9/13/2019: Kansas State University / Washburn University on the cutting edge of all things legal and tax in School of Law, Hutchinson Community College (Hutchinson, agriculture. Each annotation is a concise summary of the Kansas) particular development with just enough technical • Farm Income Tax Seminar information for practitioners to use for additional 9/17/2019: Kentucky Farm Business Management research purposes. Association (Lexington, Kentucky) • Farm Income Tax Seminar Articles 9/20/2019: University of Illinois Tax School (Rock Island, IL) http://washburnlaw.edu/practicalexperience/agricultur • Farm Income Tax Seminar allaw/ waltr/articles/index.html 9/23/2019: University of Illinois Tax School (Champaign, IL) • Farm Tax Conference 10/1/2019: California Society of CPAs (Fresno, CA) Roger on the Air Professor McEowen regularly appears on radio and Textbook/Casebook television programs heard nationally and on the Principles of Agricultural Law is Prof. McEowen’s internet. He is regularly featured on: 850-page textbook/casebook on agricultural law. It is RFD TV (and Sirius Satellite Radio) presently in it’s 44th edition. In 2017, Prof. McEowen, WIBW Radio’s “Kansas Ag Issues Podcast” (Ag-Issues) published “Agricultural Law in a Nutshell” via West • Kansas St. Univ. Radio Network (“Agriculture Today”) Academic Publishing Co. • •

SCHOOL OF LAW Rural Law & Agricultural Law Washburn Law recognizes the importance of both preparing students to practice the unique art of rural law in farming and ranching communities; and to practice agricultural law for agribusiness, which is the business of agricultural production. We also are dedicated to ensuring the availability of effective legal representation in rural communities.

RURAL LAW PROGRAM AGRICULTURAL LAW PROGRAM • Focus on identifying rural employment • Agricultural Law relates to agribusiness, opportunities across Kansas, particularly which is conducted worldwide in rural in the northwest and southwest, and communities and large metropolitan areas. preparing students to transition from legal It is a specialized area that is often treated in education and externships to actual practice unique ways by U.S. legal and tax systems. opportunities following graduation. • Externships available, as well as free • A grant from the Dane G. Hansen admittance to relevant Continuing Legal Foundation allows Washburn Law to offer Education (CLE). an immersive externship experience in one of the 26 counties the Hansen Foundation COURSEWORK* serves in northwest Kansas. • Curricula includes: agricultural law, farm and • Externship students are partnered with ranch taxation, water law, environmental practicing attorneys or judges in one of the law, administrative law, estate and family covered counties to learn the work done by law, oil and gas law, mining law, renewable those rural legal professionals. energy law, and real estate transactions. STUDENT ORGANIZATIONS OPPORTUNITIES • The seeks • The Rural Legal Practice Initiative Agricultural Law Society to create educational opportunities for partnership with Kansas State University the next generation of legal leaders, allows prelaw students to learn about legal emphasizing the importance of an ag- career opportunities in rural communities. friendly society. • Externships, internships, and research • The provides assistant positions are available, as well Rural Practice Organization development and networking opportunities as free admittance to relevant Continuing for students interested in employment in Legal Education (CLE). rural communities.

*Course list is not exhaustive and is subject to change. WASHBURNLAW.EDU/AGRICULTURE Third Year Anywhere Become practice-ready by externing in the area you plan to work after graduation with Washburn Law’s Third Year Anywhere enrollment option.* Earn credit while gaining real-world experience working 20 hours a week in one of six sectors: corporate, government, higher education, judicial, law firm, or public interest. Opportunities also exist in underserved rural locations.

* Enrollment is competitive and limited to students the faculty deem best prepared to benefit from an out-of-residence practicum and distance education. washburnlaw.edu/thirdyearanywhere

TM TABLE OF CONTENTS

THE I.R.C. §199A EXPERIENCE FROM THE 2018 FILING SEASON ...... 1

PROPOSED REGULATIONS ...... 1

COMPARING THE PROPOSED REGULATIONS WITH THE FINAL REGULATIONS ...... 2

AGRICULTURAL COOPERATIVES ...... 16

THOUGHTS ON RENTAL ACTIVITIES AND Q & A ...... 19

The Qualified Business Income (QBI) Deduction – What a Mess! ...... 29

Congress Modifies the Qualified Business Income Deduction ...... 32

Qualified Business Income Deduction – Proposed Regulations ...... 36

The Qualified Business Income Deduction and “W-2 Wages"...... 40

QBID Final Regulations on Aggregation and Rents – The Meaning For Farm and Ranch

Businesses ...... 41

The QBID Final Regulations – The “Rest of the Story” ...... 45

Ag Cooperatives and the QBID – Initial Guidance ...... 49

SELECTED TOPICS IN AG TAXATION ...... 53

PART ONE – PROPOSED/NEW LEGISLATION; IRS DEVELOPMENTS/REGULATIONS ...... 53

PART TWO – IMPACT OF THE TAX CUTS AND JOBS ACT (TCJA) ON AG CLIENTS ...... 62

LOSS LIMITATION FOR NON-CORPORATE TAXPAYERS ...... 62

SHOULD PURCHASED LIVESTOCK BE DEPRECIATED OR INVENTORIED? ...... 65

LIKE-KIND EXCHANGES (POST TCJA) ...... 68

COST SEGREGATION ...... 71

CHARACTER OF LAND SALE GAIN ...... 84

DISTINGUISHING BETWEEN A CAPITAL LEASE AND AN OPERATING LEASE ...... 86

POST-DEATH SALE OF CROPS AND LIVESTOCK ...... 88

TAX ISSUES ON REPOSSESSION OF FARMLAND ...... 90

LIFE ESTATE/REMAINDER ARRANGEMENTS AND INCOME TAX BASIS ...... 92

BITCOIN FEVER AND THE TAX MAN ...... 95

RECENT CASES AND RULINGS ...... 98

INCOME ITEMS ...... 98

SELF-EMPLOYMENT TAX ...... 98

EXCLUSION/EXEMPTION/DEFERRAL FROM INCOME ...... 98

ACCOUNTING ...... 101

MISCELLANEOUS ...... 102

DEDUCTION ITEMS ...... 103

LOSSES...... 103

CHARITABLE DEDUCTION ...... 109

MARIJUANA ...... 114

RECORDKEEPING ...... 115

MISCELLANEOUS ...... 116

ADMINISTRATIVE/PROCEDURAL ...... 118

CHANGE IN SUBSTANTIVE LAW ...... 118

IRS/COURT “GUIDANCE” ...... 118

CREDITS ...... 133

RESEARCH AND EXPERIMENTAL EXPENSES ...... 133

PREMIUM ASSISTANCE TAX CREDIT ...... 134

MISCELLANEOUS ...... 135

DEPRECIATION TOPICS ...... 137

DEPRECIABLE RECOVERY PERIODS FOR FARM ASSETS ...... 137

FARMERS AND THE SECTION 179 DEDUCTION ...... 142

FARMERS AND 100% BONUS DEPRECIATION ...... 155

REPAIR REGULATIONS ...... 158

SECTION 263A INVENTORY CAPITALIZATION AND FARMERS ...... 161

PREPAID FARM EXPENSES ...... 164

FERTILIZER ALLOCATIONS AND ELECTIONS ...... 169

SOIL AND WATER CONSERVATION EXPENDITURES ...... 172

INVENTORY ACCOUNTING ...... 174

THE PASSIVE LOSS RULES...... 176

MATERIAL PARTICIPATION ...... 176

REAL ESTATE PROFESSIONALS ...... 179

TRUSTS ...... 184

SELF-RENTALS ...... 185

THE 2018 FARM BILL ...... 190

AGI LIMITATIONS ...... 190

DEFINITION OF AGI ...... 190

PAYMENT LIMITATIONS ...... 190

AGI AND PAYMENT LIMITATION PLANNING ...... 191

AGRICULTURAL RISK COVERAGE (ARC) ...... 191

PRICE LOSS COVERAGE (PLC) ...... 192

ARC/PLC ELECTION AND ADMINISTRATION ...... 192

DAIRY MARGIN COVERAGE ...... 192

CONSERVATION ...... 193

CROP INSURANCE ...... 193

FEDERAL FARM PROGRAM PARTICIPATION ...... 194

AG DISASTERS AND CASUALTIES ...... 197

USDA LIVESTOCK INDEMNITY PROGRAM PAYMENTS ...... 197

FARM-RELATED CASUALTY LOSSES AND INVOLUNTARY CONVERSIONS ...... 199

TREATMENT OF FARMING CASUALTY AND THEFT LOSSES ...... 202

LIVESTOCK SOLD OR DESTROYED BECAUSE OF DISEASE ...... 203

ROGER A. McEOWEN KANSAS FARM BUREAU PROFESSOR OF AGRICULTURAL LAW AND TAXATION WASHBURN UNIVERSITY SCHOOL OF LAW [email protected] www.washburnlaw.edu/waltr @WashburnWaltr

PAUL G. NEIFFER PRINCIPAL, CIFTONLARSONALLEN, LLP [email protected]

iii

SESSION ONE – 8:00-9:30 a.m.

THE I.R.C. §199A EXPERIENCE FROM THE 2018 FILING SEASON

I. I.R.C. §199A – Qualified Business Income Deduction

A. Proposed regulations.

1. On August 8, 2018, the Treasury issued proposed regulations under I.R.C. §199A that was created by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017. REG-107982. Those proposed regulations are intended to provide taxpayers guidance on planning for and utilizing the new 20 percent pass-through deduction (known as the QBID) available for businesses other than C corporations for tax years beginning after 2017 and ending before 2026.

2. While some aspects of the proposed regulations are favorable to agriculture, other aspects create additional confusion, and some issues are not addressed at all.

3. The proposed regulations provide a favorable aggregation provision that allows a farming operation with multiple businesses (e.g., row-crop; livestock; etc.) to aggregate the businesses for purposes of the QBID. This is, perhaps, the most important feature of the proposed regulations with respect to agricultural businesses because it allows a higher income farming or ranching business to make an election to aggregate their common controlled entities into a single entity for purposes of the QBID.

4. In several areas, the proposed regulations are helpful to farming and ranching operations. These include an aggregation rule that allows a farmer to combine the rental income from one entity with the farm income from another entity and compute the QBID based on the combined net income (and wages and qualified property if the taxpayer is over the applicable income threshold).

5. Similar to the benefit of aggregation, farms with multiple entities can allocate qualified W-2 wages to the appropriate entity that employs the employee under common law principles. This avoids the taxpayer being required to start payroll in each entity.

6. Likewise, carryover losses that were incurred before 2018 and that are now allowed in years 2018-2025 will be ignored in calculating qualified business income (QBI) for purposes of the QBID. This is an important issue for taxpayers that have had passive losses that have been suspended under the passive loss rules. Although if the net ordinary income of the farmer is low, the actual benefit may be very minor.

a. The passive loss rules of I.R.C. §469 are applied before determining QBI. For example, if a rental activity incurs a $10,000 loss in 2018, but I.R.C. §469 only allows $5,000 of the loss to be netted against another rental with $5,000 of income, net QBI will be zero. The rental loss to be carried forward from 2018 is $5,000 and the QBI loss carryforward will be zero since the net passive loss carryover of $5,000 has not yet been recognized.

b. Attention should be paid to ensure that tax software is treating I.R.C. §469 loss carryovers properly.

7. For farmers that also do consulting, a favorable rule is included that this “specified service trade or business” (SSTB) income is ignored if it is less than 10 percent of overall income from the business if average gross revenues are less than $25 million. In that instance, the income will be treated as “normal” business income for QBID purposes.

8. Under the proposed regulations, if a farmer or rancher only has one business and the business shows a loss, a QBID cannot be claimed in the current year and the loss will carry forward to the following year as a “separate” item of qualified business income (QBI). However, for farming and ranching business multiple entities, if one entity shows a loss, that loss must be netted against the income of the other entities. For taxpayers that are beneath the income threshold, the net amount is multiplied by 20 percent to compute the QBID. For taxpayers over the threshold, the proposed regulations contain a calculation procedure that will be favorable for farmers, ranchers and other taxpayers.

9. The proposed regulations confirm that real estate leasing activities can qualify for the QBID without regard to whether they are active or passive in nature. See, e.g., Prop. Treas. Reg. §1.199A-1(d)(4), Examples 1 and 2. That is certainly the case if the rental is between “commonly controlled” entities. For rentals not between commonly controlled entities, the income is QBI if the rental activity constitutes a trade or business under I.R.C. §162.

B. Comparing the proposed regulations with the final regulations issued on January 18, 2019.

Note - The final regulations are effective upon being published in the Federal Register. But, in general, a taxpayer can rely on either the final or proposed regulations for tax years that end in 2018. Some parts of the final regulations apply to tax years ending after December 22, 2017, or to tax years ending after August 16, 2018. However, these situations apply to the anti-abuse rules, including the anti-abuse rules that apply to trusts.

1. Losses

a. Proposed regulations. Under the proposed regulations, carryover losses that were incurred before 2018 and that are now allowed in years 2018-2025 will be ignored in calculating qualified business income (QBI) for purposes of the QBID. This is an important issue for taxpayers that have had passive losses that have been suspended under the passive loss rules. While this loss allocation rule is generally favorable, clarification was needed on a couple of points. For instance, could a taxpayer also ignore pre-2018 suspended losses for purposes of the Excess Business Loss rule under I.R.C. §461(l)?

b. Final regulations. The final regulations, consistent with the regulations issued under former I.R.C. §199, provide that any losses that are disallowed, suspended, or limited under I.R.C. §469 (passive loss rules) §704 and I.R.C. §1365 (or any other similar provision) are to be used on a first-in, first-out basis.

i. In addition, the final regulations clarify that an NOL deduction (in accordance with I.R.C. §172) is generally not considered to be in connection with a trade or business. Excess business losses (the amount over $500,000 (mfj)) are not allowed for the tax year.

ii. However, an Excess Business Loss (EBL) under I.R.C. §461(l) is treated as an NOL carryover to the next tax year where it reduces QBI in that year to the extent that the EBL is recognized. The carry forward becomes part of the taxpayer's NOL

carryforward in later years. There is no mention whether this amount gets retested under I.R.C. §461(j) (involving subsidized farming losses). Under prior law, those disallowed losses retained their character in a later tax year. That is no longer the case and it appeared that the NOL generated under I.R.C. §461(l) would not be subject to other loss limitation provisions.

2. Included and Excluded Items

a. Under the proposed regulations, QBI includes net amounts of income, gain, deduction, and loss with respect to any qualified trade or business. I.R.C. §199A(c).

b. Business-related items that constitute QBI include ordinary gains and losses from Form 4797; deductions that are attributable to a business that is carried on in an earlier year; the deduction for self-employed health insurance under I.R.C. §162(l); the deductible portion of self-employment tax under I.R.C. §164(f); and retirement plan contributions attributable to QBI.

c. The final regulations are consistent with the proposed regulations on the treatment of the self-employed health insurance deduction and retirement plan contributions. Prop. Treas. Reg. §1.199A-1(b)(4) defines QBI as the net amount of qualified items of income, gain, deduction and loss with respect to a trade or business as determined under the rules of Prop. Treas. Reg. §1.199A-3(b). The above-the-line adjustments for S.E. tax, self-employed health insurance deduction and the self-employed retirement deduction are examples of such deductions.

i. QBI is reduced by certain deductions reported on the return that the business doesn’t specifically pay, including the deduction for one-half of the self- employment tax, the self-employed health insurance deduction, and retirement plan contributions.

ii. The self-employed health insurance deduction may only “apply” to Schedule F farmers because, with respect to partnerships and S corporations, it is actually a component of either shareholder wages for an S corporation shareholder or guaranteed payments to a partner and, thus, may not reduce QBI.

iii. The self-employed health insurance deduction should not be removed from an S- corporate owner on their individual return because it has already been removed on Form 1120-S. Do not deduct it twice. If QBI were reduced by the amount of the I.R.C. §162(l) deduction on the 1040, QBI would be (incorrectly) reduced twice. In other words, QBI should not be reduced by the self-employed health insurance from the S corporation or the partnership. The deduction for the S corporation shareholder is allocated to the wage income, and the deduction for the partner is from the guaranteed payment.

iv. The one-half self-employment tax deduction for the partner is allocated between guaranteed payments (if any) and that portion of the K-1 allocated income associated with QBI.

Note: Some tax software programs are not treating this properly. Watch for updates, such as a box to check on the self-employed health insurance screen.

d. The final regulations also clarify that the deduction for contributions to qualified retirement plans under I.R.C. §404 is considered to be attributable to a trade or business to the extent that the taxpayer’s gross income from the trade or business is accounted for when calculating the allowable deduction, on a proportionate basis. See Prop. Treas. Reg. §1.199A-3(b)(vi).

i. When an S corporation makes an employer contribution to an employer-sponsored retirement plan, that contribution, itself, reduces corporate profits. Thus, there is less profit on which the QBID can potentially apply. Thus, for some S corporation owners, a contribution to an employer-sponsored retirement plant will effectively result in a partial deduction, but still subject the entire contribution, plus all future earnings, to income tax upon distribution.

ii. The final regulations make clear that sole proprietors and partners must also “back out” these amounts from business profits before applying the QBID. This rule will make 401(k)s with a Roth-style option more valuable.

iii. It is noted that business owners of an SSB with income high enough to phase-out the QBID and those who believe their future marginal tax rate will be significantly lower than the present marginal tax rate, as well as those who need to reduce their AGI to qualify for other deductions, credit, etc.

e. The final regulations do not address how deductions for state income tax imposed on the individual’s business income or unreimbursed partnership expenses are to be treated.

f. The final regulations also don’t mention whether the deduction for interest expense to a partnership interest or an S corporation interest is business related.

g. Some tax software is presently reducing QBI passed through from an S corporation or partnership by the I.R.C. §179 amount which is passed through separately. Other tax software allows the practitioner to either include or exclude the I.R.C. §179 amount. A suggested approach is to always exclude it at the entity level because it is not known if it can be deducted on the taxpayer’s personal return. Operating properly, tax software should calculate QBI with a reduction for the I.R.C. §179 deduction at the individual level.

h. Guaranteed payments for the use of capital in a partnership are not attributable to the partnership’s business, unless they are properly allocable to the recipient’s qualified trade or business (not likely).

i. Also excluded from QBI are amounts that an S corporation shareholder receives as reasonable compensation or amounts a partner receives as payment for services under I.R.C. §§707(a) or (c).

3. Capital Gain/Loss. The QBID is limited to the lesser of 20 percent of taxable income less “net capital gains” as defined in I.R.C. §1(h).

a. The I.R.C. §1(h) definition includes: long-term capital gains; qualified dividend income; I.R.C. §1231 gain not taxed as ordinary income (they are ordinary to the extent of unrecaptured net I.R.C. §1231 losses from the prior five years); I.R.C. §1250

gains (i.e., gain from real estate sales representing depreciation claimed); long-term rate for collectibles. b. The proposed regulations appeared to take the position that gain that is “treated” as capital gain is not QBI. Prop. Treas. Reg. 1.199A-3(b)(2)(ii)(A).

i. This interpretation would exclude I.R.C. §1231 gain (such as is incurred on the sale of breeding livestock) from being QBI-eligible. But, it could also be argued that is an incorrect interpretation of the relevant Code provisions. It also is arguably inconsistent with the purpose of the QBID statute. I.R.C. §1222(3) defines long-term capital gain as the gain from the sale or exchange of a capital asset held for more than one year, if and to the extent the gain is taken into account in computing gross income. I.R.C. §1231(a)(1) treats the I.R.C. §1231 gains as long-term capital gain. I.R.C. §199A(a)(2)(B) neither modifies nor makes any other specification.

ii. Also, I.R.C. §1222(11) defines “net capital gain” as the excess of the net long- term capital gain for the year over the net short-term capital loss. None of the other provisions on I.R.C. §1222 mention I.R.C. §1231. Simply because, as the proposed regulations state, gain is “treated as” capital gain does not make it capital gain. Rather, “treated as” should be read in a manner that the tax on I.R.C. §1231 gain is computed in the same manner as capital gain.

iii. I.R.C. §1231 reflects gain on the disposition of a business asset. As such, the argument is, I.R.C. §1231 gain should be QBI because the purpose of I.R.C. §199A is to provide a lower tax rate on business income. Losses from the sale of short-term depreciable assets (Part II of Form 4797) should not reduce QBI if I.R.C. §1231 gains (Part 1 of Form 4797) are present.

c. The final regulations remove the specific reference to I.R.C. §1231 and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of these under any Code provision, is not taken into account as a qualified item of income, gain, deduction or loss.

i. Comprehensive definition.

ii. Includes any item that is reported on Schedule D plus qualified dividends. Qualified dividends are specifically included in the term “capital gain” by reference to I.R.C. §1(h).

iii. The I.R.C. §1231 gain character is determined at the shareholder level.

iv. If I.R.C. §1231 netting yields a loss, all of the I.R.C. §1231 gains and losses are treated as ordinary. This may require the practitioner to modify the QBI figure that was reported out on the K-1.

4. Commodity trading.

a. The proposed regulations provided that “brokering is limited to trading securities for a commission or a fee. Prop. Treas. Reg. §199A-5(b)(2)(x).

i. Clarification was needed to ensure that brokering of commodities did not constitute a specified service trade or business (SSTB). An SSTB is eligible for the QBID, but under a different set of rules that apply to non-SSTB businesses (such as farms and ranches).

ii. For instance, the concern was that under the proposed regulations a person who acquired a commodity (such as wheat or corn for a hog farm), and transported it to the ultimate buyer might improperly be considered to be dealing in commodities. This would have resulted in the income from the activity treated as being from an SSTB. None of the commodity income would have been eligible for the QBID for a high-income taxpayer.

iii. This is also an important issue for private grain elevators. A private grain elevator generates income from the storage and warehousing of grain; it also generates income from the buying and selling of grain. Is the private elevator’s buying and selling of grain “commodity dealing” for purposes of I.R.C. §199A? If it is, then a significant portion of the elevator’s income will not qualify for the QBID.

b. The final regulations clarify that the physical handling, storage or transportation of agricultural commodities does not constitute an SSTB and does so by pointing to I.R.C. §954.

5. W-2 wages.

a. The final regulations specify that the IRS may provide for methods of computing taxable wages.

b. Simultaneously with the release of the final regulations, the IRS issued Rev. Proc. 2019-11. The Rev. Proc. notes that it applies only for QBID purposes, and recites the W-2 wages definition from the proposed regulations. Thus, statutory employees that a have a Form W-2 with Box 13 marked are not W-2 wages for QBID purposes.

c. Wages paid in-kind to agricultural labor are not eligible W-2 wages, but wages paid to children under age 18 are. For the background statutory analysis of this issue see: https://lawprofessors.typepad.com/agriculturallaw/2018/08/the- qualified-business-income-deduction-and-w-2-wages.html.

d. The proposed regulations set forth three methods for computing W-2 wages – unmodified box method; modified box 1 method; and the tracking wages method. The Rev. Proc. also provided special rules to use for a short tax year which requires the use of the tracking wages method.

e. Contractor payments made on Forms 1099 are not wages for QBID purposes. The regulations create a rebuttable presumption for three years that an individual is an employee.

6. Multiple trades or businesses.

a. The final regulations follow the approach of the proposed regulations concerning a taxpayer that has multiple trades and businesses.

b. Items of QBI that are properly allocable to more than a single trade or business must be allocated among the several trades or businesses to which they are attributed using a reasonable method based on the facts. That method is to be consistently applied each year.

c. The same concept applies for individual items.

d. Trades or businesses conducted by a disregarded entity will be treated as conducted directly by the owner of the entity for QBID purposes. Treas. Reg. §1.199A(e)(2).

7. Income Tax Basis

a. Under I.R.C. §199A, higher income taxpayers compute their QBID in accordance with a wages/qualified property (QP) limitation. The amount of QP that is used in the limitation is tied to the what is known as the “unadjusted basis in assets” (UBIA). However, the proposed regulations raised some questions about UBIA that needed clarified.

b. For instance, Prop. Treas. Reg. §1.199A-4(b), Example 3, needed modified. When a tax-free contribution of property to a corporation is involved, the transferor’s unadjusted basis should continue to be the UBIA. The placed-in- service date would be the date that the transferor originally placed the property in service. I.R.C. §351 should simply be viewed as a continuation of the taxpayer’s holding. The only difference is that the asset is being held via the S corporation. Indeed, the tax attributes of the contributed asset remain unchanged. Likewise, the transferor’s depreciation history with respect to the contributed asset carries into the S corporation. Thus, the unadjusted basis should also carry into the corporation.

c. The final regulations clarify that the UBIA of property received in either an I.R.C. §1031 or 1033 exchange is the UBIA of the relinquished property. In addition, the placed-in-service date of the replacement property is the service date of the relinquished property. Similar concepts apply for transfers that are governed by I.R.C. §§351, 721 and 731.

d. The final regulations also take the position that property contributed to a partnership or S corporation under the non-recognition rules retains the UBIA of the contributor. In addition, an I.R.C. §743(b) adjustment is QP to the extent of an increase in fair market value over original cost.

i. On February 1, 2019, the Treasury released corrected draft final regulations under I.R.C. §199A.

ii. The corrections include, among other things, corrections to the definition and computation of excess I.R.C. §743(b) basis adjustments

for purposes of determining the UBIA immediately after an acquisition of qualified property, as well as corrections to the description of an entity disregarded as separate from its owner for purposes of the QBID.

iii. An I.R.C. §743(b) basis adjustment is to be treated as qualified property to the extent the adjustment reflects an increase in the FMV of the underlying qualified property.

iv. An “excess I.R.C. §743(b) basis adjustment” is an amount that is determined with respect to each item of qualified property and is equal to an amount that would represent the partner’s I.R.C. §743(b) basis adjustment with respect to the property as determined under Treas. Reg. §1.743-1(b) and Treas. Reg. §1.755-1, but calculated as if the adjusted basis of all of the partnership’s property was equal to the UBIA of such property.

v. The absolute value of the excess I.R.C. §743 basis adjustment cannot exceed the absolute value of the total I.R.C. §743(b) basis adjustment with respect to qualified property.

vi. The excess I.R.C. §743(b) basis adjustment is treated as a separate item of qualified property placed in service when the transfer of the partnership interest occurs.

vii. The rule in vi. above is limited solely to the determination of the depreciable period for QBID purposes. It does not apply to the determination of the placed in service date for depreciation or tax credit purposes.

viii. The recovery period for such property is determined under Treas. Reg. §1.743-1(j)(4)(i)(B) with respect to positive basis adjustments and Treas. Reg. §1.743-1(j)(4)(ii)(B) with respect to negative basis adjustments.

ix. I.R.C. §743(b) is the adjustment. I.R.C. §754 is simply the election to put it on the partnership books. I.R.C. §754 is allowed when an I.R.C. §743(b) adjustment is made, but not I.R.C. §734(b).

e. For entities, the UBIA is measured at the entity level, and the property must be held by the entity as of the end of the entity’s tax year.

f. As for a decedent’s estate, the fair market value of property that is received from a decedent pegs the UBIA and the new depreciation period (for purposes of the computation of the limitation) is reset as of the date of the decedent’s death.

8. Trusts

a. The final regulations specify that a non-grantor trust that is established for “a primary purpose” of avoiding income tax under I.R.C. §199A will be considered to be aggregated with trust settlor/grantor for QBID purposes.

b. In addition, distributable net income (DNI) transferred from a non-grantor trust to a beneficiary is treated as having been received by the beneficiary. This could lead to an increase in the creation of non-grantor, irrevocable, complex trusts.

c. The final regulations also did not place any limitation on the use of irrevocable trusts that are considered to be owned by the beneficiary(ies). See I.R.C. §678.

d. However, this does not necessarily mean that there should be a rush to create irrevocable trusts. The IRS, supported by the courts, often view the substance of a transaction as more controlling than form when it believes that the entity was created primarily for tax avoidance purposes. See, e.g., Helvering v. Gregory, 293 U.S. 465 (1935).

9. Miscellaneous

a. Under the final regulations, a veterinarian is engaged in the provision of health care and, therefore, is an SSTB.

b. No clarity was given as to the treatment of insurance salesmen – they are often statutory employees

c. The final regulations contain a three-year lookback period on the reclassification of workers from employee (W-2) status to independent contractor (Form 1099) reporting. Employees do not have QBI, but independent contractors can.

10. Aggregation – multiple businesses

a. The proposed regulations provide a favorable aggregation provision that allows a farming operation with multiple businesses (e.g., row-crop; livestock; etc.) to aggregate the businesses for purposes of the QBID.

b. This was, perhaps, the best feature of the proposed regulations with respect to agricultural businesses because it allows a higher income farming or ranching business to make an election to aggregate their common controlled entities into a single entity for purposes of the QBID. This is particularly the case with entities having paid no wages or that have low or no qualified property.

c. Entities with cash rental income already qualified the income as QBI via common ownership (common ownership is required to aggregate)

d. Once the applicable threshold for 2018 ($157,500 for a single filer; $315,000 for a married filing joint return) is exceeded, the taxpayer must have qualified W-2 wages or qualified property basis to claim the QBID. Aggregation, in this situation, may allow the QBID to be claimed (assuming the aggregated group has enough W-2 wages or qualified property).

e. Common ownership is required to allow the aggregation of entities to maximize the QBID for taxpayers that are over the applicable income threshold. Prop. Treas. Reg. §1.199A-4(b). However, aggregation may not be needed. Only make

the aggregation election if wages or UBIA is needed to maximize QBID. Once made, the election is permanent. f. “Common ownership” requires that each entity has at least 50 percent common ownership. g. But, the common ownership rule does not require every person involved to have an ownership in every trade or business that is being aggregated, or that you look to the person’s lowest percentage ownership. For example, person A could have a 1 percent ownership interest in entity X and a 99 percent ownership interest in entity Y, and an unrelated person could have the opposite ownership (99 percent in X and 1 percent in Y) and the entities would have common ownership of 100 percent (the group of people have 50 percent or more common ownership). h. The proposed regulations limited family attribution to just the spouse, children, grandchildren and parents. See Prop. Treas. Reg. §1.199A-4(b)(3). In other words, the proposed regulations limited common ownership to lineal ancestors and descendants.

i. Excluded were siblings – which are often involved in farming and ranching businesses.

ii. One way to plan around the lack of sibling attribution, for example, was to have one child own 100 percent of one business and another child of the same parent own 100 percent of another business. In that situation, the parent is deemed to have 100 percent ownership of both businesses even though there is no sibling attribution. The two businesses could be aggregated, even though there is no sibling attribution, as long as at least one parent is alive. i. The proposed regulations were also unclear concerning whether (for taxpayers over the applicable income threshold) it mattered if the entities are on a calendar or fiscal year-end. j. In order to elect to aggregate entities together, the proposed regulations required all of the entities in a combined group must have the same year-end, and none can be a C corporation. But, rental income paid by a C corporation in a common group could be QBI if the C corporation was part of that combined group.

i. If this reading were correct, that meant that the rental income could qualify as QBI.

ii. That interpretation is beneficial to farming and ranching businesses – many are structured with multiples entities, at least one of which is a C corporation. k. The final regulations provide that siblings are included as related parties via I.R.C. §§267(b) and 707(b).

i. Including siblings in the definition of common ownership for QBID purposes will be helpful upon the death of the senior generation of a farming or ranching operation.

ii. In addition, the final regulations retain the 50 percent test and clarify that the test must be satisfied for a majority of the tax year, at the year-end, and that all of the entities of a combined group must have the same year-end.

l. The final regulations also specify that aggregation for 2018 can be made on an amended return. The aggregation election can be made in a later year if it was not made in the first year.

11. Rental Activities

a. The proposed regulations confirmed that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s particularly the case if the rental is between “commonly controlled” entities.

b. But, the proposed regulations could also have meant that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID.

i. If this is correct, it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID.

ii. Clarification was needed on the issue of whether the rental of property, regardless of the lease terms will be treated as a trade or business for aggregation purposes as well as in situations when aggregation is not involved.

iii. Clarification is critical because cash rental income may be treated differently from crop-share income depending on the particular Code section involved. See, e.g., §1301.

c. The proposed regulations also contained an example of a rental of bare land not requiring any cost on the landlord’s part. See Prop. Treas. Reg. §1.199A-1(d)(4), Example 1.

i. This seemed to imply that the rental of bare land to an unrelated third party qualifies as a trade or business.

ii. Another example in the proposed regulations also seemed to support this conclusion. Prop. Treas. Reg. §199A-1(d)(4), Example 2. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. Clarification on this point was also needed.

d. Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations created confusion.

i. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162.

ii. But, the Preamble also stated that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, the Preamble raised a question as to whether those separate rental activities can’t be aggregated unless each rental activity is a trade or business.

iii. The Preamble also raised a question as to whether the Treasury would be making the trade or business determination on an entity-by-entity basis. If so, triple net leases might not generate QBI.

iv. But, another part of the proposed regulations extended the definition of trade or business beyond I.R.C. §162 in one circumstance when it referred to “each business to be aggregated” in paragraph (ii). Prop. Treas. Reg. §1.199A- 4(b)(i). This would appear to mean that the rental of property would be treated as a trade or business for aggregation purposes. See Prop. Treas. Reg. §199A- 1(b)(13). e. The final regulations removed the bare land rent example in the proposed regulations.

i. Unfortunately, no further details were provided on the QBI definition of trade or business. That means that each individual set of facts will be key with the relevant factors including the type of rental property (commercial or residential); the number of properties that are rented; the owner’s (or agent’s) daily involvement; the type and significance of any ancillary services; the terms of the lease (net lease; lease requiring landlord expenses; short-term; long-term; etc.).

ii. Certainly, the filing of Form 1099 will help to support the conclusion that a particular activity constitutes a trade or business. But, tenants-in-common that don’t file an entity return create the implication that they are not engaged in a trade or business activity. f. The final regulations clarify that rental paid by a C corporation cannot create a deemed trade or business.

i. This is a tough outcome as applied to many farm and ranch businesses and will require some thoughtful discussions with tax/legal counsel about restructuring rental agreements and entity set-ups.

ii. Before the issuance of the final regulations, it was believed that land rent paid by a C corporation could still qualify as a trade or business if the landlord could establish responsibility (regularity and continuity) under the lease. Landlord responsibility for mowing drainage strips (or at least being responsible for ensuring that they are mowed) and keeping drainage

maintained (i.e., tile lines), paying taxes and insurance and approving cropping plans, were believed to be enough to qualify the landlord as being engaged in a trade or business. This appears to still be the case under the final regulations if the underlying activity is a trade or business even though a C corporation cannot qualify under the common control test. g. Along with the release of the final regulations, the IRS issued Notice 2019-7 (Jan. 18, 2019). The Notice is applicable for tax years ending after December 31, 2017 and can be relied upon until the final Revenue Procedure is published.

i. The Notice provides tentative guidance and a request for comments on the sole subject of when and if a rental activity (termed as a “rental real estate enterprise) will be considered to be an active trade or business.

ii. The Notice also provides a safe harbor. While real estate rented or leased under a triple net lease is not eligible under the safe harbor (unless common control allows it), a taxpayer who has an active business of entering into and selling triple net leases may still be considered to be sufficiently active to qualify as a trade or business under existing case law.

iii. The Notice defines a triple net lease to include an agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance in addition to rent and utilities, and includes leases that require the tenant to pay common area maintenance expenses, which are when a tenant pays for its allocable portion of the landlord’s taxes, fees, insurance, and maintenance activities which are allocable to the portion of the property rented. The definition seems to leave open the ability to avoid triple net lease status by having the tenant be responsible for some portion of the maintenance, taxes, fees, insurances, and other expenses that would normally be payable by a landlord.

iv. Failure to meet the safe harbor does not fully preclude the lease from generating QBI.

Note: For landowners receiving annual “wind lease” income for aero generators on their farmland, even though the income is received as part of a common controlled group, the actual income is not paid by any member of the controlled group. It is essentially triple net lease income with no services provided by the farmer (or spouse). This income will not be QBI, given the inability of the landowner to provide “services” under the lease agreement. h. An individual may rely on the safe harbor, as well as a partnership or S- corporation that owns the applicable interest in the real estate that is leased out (such as farmland). As noted above, the final regulations take the position that the lessor entity must be a pass-through entity (or a sole proprietorship) that owns the real estate directly or through another entity that is disregarded for income tax purposes. Rent that is paid by a C corporation doesn’t count. i. Each individual taxpayer, estate or trust can elect to treat each separate property as a separate enterprise, or all similar properties as a single enterprise, for purposes of applying the safe harbor rules, except that commercial and residential

real estate cannot be considered as part of the same enterprise for testing purposes.

i. In other words, all commercial rents can be netted as one single enterprise, and all residential rentals can be netted as another enterprise.

ii. But, real estate that is under a triple net lease, and real estate used as a residence by the taxpayer cannot be part of an aggregated enterprise for testing purposes because they cannot qualify to be included in the safe harbor. j. The Notice specifies that for each separate enterprise, certain requirements must be satisfied each year for the enterprise’s income to be eligible for the safe harbor:

i. Maintenance of separate books and records to reflect the income and expenses for each enterprise.

ii. Aggregate records for properties that are grouped as a single enterprise.

iii. Contemporaneous records (similar to auto logs) of time reports, logs, etc., with respect to services performed and the party performing the services with respect to tax years beginning January 1, 2019. The requirement is inapplicable to 2018 returns or fiscal year filers for years ending before 2020.

iv. For tax years 2018 through 2022, 250 or more hours of “rental services” must be performed to qualify the property for the safe harbor in each calendar year. Rental services include time spent by owners, employees, agents, and independent contractors of the owners, which can include management and maintenance companies who have personnel who keep and provide contemporaneous records. Rental services also include advertising to rent or lease properties; negotiating and executing leases; verifying tenant information; collecting rent; daily management and repairs; buying materials and supervising employees and independent contractors. Starting in 2023, such hours are needed three out of five years.

v. Must include a statement on the return (under penalty of perjury) that the rental enterprise satisfies the requirements. Use of the safe harbor is done on an annual basis.

vi. To restate, the safe harbor does not apply to triple-net leases. Thus, a farm landlord that cash rents farmland via a triple-net lease will not qualify the rental income as QBI even if working more than 250 hours in the lease activity.

vii. Implications for crop-share lease income.

. For crop share lease income, the landlord must do more than simply receive a share of the crop without incurring any crop-related expenses in order to qualify the lease income as QBI.

. If the landlord shares in crop expenses, the IRS will likely argue that the landlord must clear the 250-hour hurdle. While putting in less than 250

hours doesn’t mean the lease income is not QBI, the landlord bears the burden to prove that it is.

. Structured rental situations involving common ownership avoids the safe harbor restrictions (and under the final regulations “related parties” includes brothers and sisters). Thus, rent paid by an individual or pass- through entity to an individual or pass-through entity under common ownership qualifies as QBI. If rent is paid by a C corporation under common ownership, it will not qualify as QBI, unless safe harbor rules satisfied (and (likely) self-employment tax is paid).

k. The safe harbor requirements will most likely be easier to satisfy by taxpayers having multiple properties, and cannot be used by a taxpayer that rents their personal residence(s) out for part of the year. While most rental house scenarios, cash rents and crop shares won’t qualify for the safe harbor, they may qualify under common control without regard to any hour requirement, or they can still generate QBI based on the overall facts and circumstances.

l. The common ownership rules trump the safe harbor rules. Thus, qualifying the income of rental entities as QBI (e.g., land held outside a farming operating entity that is leased to the farming entity) via common ownership will not necessarily make the rental income that passes through to the owners subject to self- employment tax. The only time the safe harbor rules apply is when rent is received from an entity that is not part of a common group.

i. If a farm entity pays rent to a sole proprietor farmer or pass-through entity with common ownership, no hours are required related to the rental income. The rental income, by default, qualifies as QBI unless it is paid by a C corporation.

ii. In this situation, the lease could be a passive lease. If the rental amount is set at fair market value, none of the income is subject to self-employment tax. See, e.g., Martin v. Comr., 149 T.C. No. 12 (2017).

iii. Under the proposed regulations, rents could by paid by a C corporation under common ownership and the rental income would qualify as QBI. Under the final regulations, the rent must be paid by an individual or “relevant pass- through entity” (RPE). But, for farmers that farm as a C corporation and pay rent to themselves or an RPE, the rental income is QBI for 2018 via the proposed regulations. None of such rent will count as QBI for 2019 and later years. While the safe harbor can be utilized for post-2018 years, it requires the landlord put in at least 250 hours in the activity (which may trigger self- employment tax).

12. Based on the final regulations, the IRS announced that it would be making changes to various Forms, Schedules and Instructions and re-posting them to the IRS website. Impacted are the Instructions for the Form 1040; Instructions for the Form 1065; Schedule K-1 Instructions for the Form 1120-S; Instructions for the Form 1120-S; Schedule K-1 Instructions for the Form 1041 and Instructions for the Form 1041, Schedule K-1.

C. Agricultural Cooperatives

1. As initially enacted, I.R.C. §199A provided for a 20 percent deduction on gross sales to an agricultural cooperative.

2. As amended, the incentive provided to a farmer to sell to an agricultural cooperative as opposed to a private grain buyer was removed and a transition rule put in place.

a. The transition rule specifies that a farmer’s calculation of their QBID for 2018 does not include grain sold to a cooperative if the cooperative accounted for those sales when calculating its domestic production activities deduction (DPAD) under former I.R.C. §119 on its 2018 return.

b. The transition rule will have an impact on many patrons

c. Patrons that receive qualified payments from cooperatives with fiscal years that begin in 2017 and end in 2018 are subject to the transition rule.

i. For these patrons, a DPAD can be claimed (under the former rules) if the cooperative passed through the DPAD.

ii. Such payments cannot be considered in the calculation of the patron’s 2018 QBID.

iii. The Joint Committee on taxation confirms this tax treatment in its Bluebook of December 2018.

iv. A cooperative must report to the patron the amount of qualified payments made to the patron in 2018 that were included in the cooperative’s DPAD computation from January 1, 2018 to the last day of the cooperative’s fiscal year ending in 2018.

d. As in the non-cooperative setting, a patron of a cooperative cannot be a C corporation and benefit from the QBID.

e. The transition rule has no application to grain sales to non-cooperatives.

f. The transition rule only affects 2018 farm income tax returns other than certain fiscal year returns. The timing of grain sales to a cooperative will not impact the QBID calculation for 2019 and beyond.

g. A farmer cannot use any of the sales to a cooperative between January 1, 2018 and the cooperative’s 2018 year-end in calculating the QBID (e.g., new DPAD). It is immaterial if the farmer is over or under the income threshold. Net income related to such payments will not be QBI and also will not qualify for the DPAD (old). The only deduction that the farmer may qualify for is the old DPAD that the cooperative passes through (if any). But, this DPAD may have already been passed out by the cooperative in late 2017 resulting in no deduction in 2018.

h. A farmer must reduce their QBID (e.g., new DPAD) by the lesser of: (1) 9 percent of QBI related to cooperative payments; or (2) 50 percent of wages allocated to cooperative net income.

i. A farmer can deduct the DPAD (old or new) that is passed through from the cooperative (limited to 100 percent of taxable income including capital gains).

j. For calendar year 2018, a patron may receive two written notices: (1) a notice of the DPAD reported on Form 8903 and which is deducted above-the-line; and (2) a notice of the new DPAD which is part of the new QBID and is reported on the special I.R.C. §199A worksheet. The DPAD shows up on line 23 and flows through to Schedule 1 on line 36 (total adjustments line). The QBID (if any) will show up as part of the QBID (I.R.C. §199A worksheet).

k. Form 1099-PATR that indicates patronage dividends, per-unit retains, DPAD, etc., does not break down the allocation between the old and new DPAD.

l. The preparation of a patron’s return requires a copy of each written notice of DPAD allocation to determine the old/new DPAD; a copy of Form 1099-PATR; and a breakdown of the sales and patronage received from the cooperative from January 1, 2018 until the cooperative’s year-end.

m. For patrons subject to the transition rule, the post-fiscal year QBID computation involves a computation of 2018 expenses that will need to be computed and allocated. In other words, the patron places income into three “buckets” (pre-fiscal yearend 2018 of the cooperative; post-fiscal yearend of the cooperative; and all others). No specific allocation of expense is necessary.

3. A cooperative passing through a portion of their deduction to the patron could raise the patron’s QBID above 20 percent.

4. A cooperative could issue non-qualified equity providing a tax benefit to the patron that would be redeemed to the patron at a later date.

5. Cash patronage paid to a patron is part of the QBID calculation.

6. Agricultural and horticultural cooperatives are allowed a deduction equal to 9% of the lesser of the cooperative’s QPAI for the year or taxable income (determined without regard to patronage dividends, per-unit retain allocations, and non-patronage distributions).

a. The deduction, however, cannot exceed 50% of the cooperative’s W-2 wages for the year that are subject to payroll taxes and are allocable to domestic production gross receipts.

b. The cooperative may choose to either claim the deduction or allocate the amount to patrons (including other specified agricultural or horticultural cooperatives or taxpayers other than C corporations).

7. An eligible patron of an agricultural or horticultural cooperative that receives a qualified payment from the cooperative can claim a deduction in the tax year of receipt in an amount equal to the portion of the cooperative’s deduction for QPAI that includes the following:

a. Allowed with respect to the portion of the QPAI to which such payment is attributable.

b. Identified by the cooperative in a written notice mailed to the patron during the payment period described in IRC §1382(d).

8. A qualified payment to a patron is any amount that meets the following three tests:

a. The payment must be either a patronage dividend or a per-unit retain allocation.

b. The payment must be received by an eligible patron from a qualified agricultural or horticultural cooperative.

c. The payment must be attributable to QPAI with respect to which a deduction is allowed to the cooperative.

9. The cooperative’s deduction is allocated among its patrons on the basis of the quantity or value of business done with or for the patron by the cooperative.

10. A patron computes the patron’s share of net profit based on the percentage of sales to the cooperative.

11. Under IRC §199A(g), a cooperative cannot reduce its income under IRC §1382 for any deduction allowable to its patrons. Thus, the cooperative must reduce its deductions that are allowed for certain payments to its patrons in an amount equal to the §199A(g) deduction allocated to its patrons.

12. A patron is allowed a deduction for amounts allocated without regard to wages expense. The only limitation at the patron level is taxable income.

13. A patron of an agricultural or horticultural cooperative that receives a QBID from the cooperative is not subject to the 20% of tentative taxable income limit. Instead, the patron’s QBID is limited to taxable income. In addition, a patron who receives a QBID from a cooperative may offset any character of income, including capital gain.

14. The patron’s deduction may not exceed the patron’s taxable income for the tax year (determined without regard to the deduction but after accounting for the patron’s other deductions under IRC §199A(a)). However, for any qualified trade or business of a patron, the initial QBID is reduced by the lesser of: (1) 9% of the QBI allocable to patronage dividends and per-unit retains received by the patron, or (2) 50% of the W-2 wages (subject to payroll tax) with respect to the business.

15. For a farmer who reports income and expenses on Schedule F, is a patron of an agricultural cooperative, and pays no qualified wages, there are two steps to calculate the tax benefits.

a. The cooperative’s final QBID that is passed through to the patron can be applied to offset the patron’s taxable income regardless of source.

b. The farmer/patron is entitled to an initial QBID equal to 20% of net farm income, subject to the wage limit that applies to taxpayers with income over the threshold amount ($315,000 for MFJ taxpayers and $157,500 for all others).

16. For farmers who pay qualified W-2 wages and sell to agricultural cooperatives that also pay W-2 wages, their initial QBID is reduced by subtracting the lesser of 50% of W-2 wages or 9% of QBI attributable to the income from the cooperative. Thus, for a farmer with farm income

beneath the threshold amount ($315,000 for MFJ taxpayers and $157,500 for all others), the QBID will never be less than 11% (i.e., 20% less 9%).

17. If the farmer is above the income threshold amount, the W-2 wages/QP limit is applied before the 9% limitation. The farmer’s QBID cannot exceed 20% of taxable income. To this amount is added any pass-through deduction from the cooperative to produce the total deductible amount.

18. For farmers who sell agricultural products to non-cooperatives and pay W-2 wages, a deduction of 20% of net farm income is available. If taxable income is less than net farm income, the deduction is 20% of taxable income less capital gains. If taxable income before the QBID exceeds the income threshold amount, the deduction may be reduced on a phased-in basis.

19. Whether a taxpayer receives an advantage from selling agricultural products to a cooperative depends on various factors.

a. In general, a farmer with farm income over the applicable income threshold for their filing status obtains a larger QBID by paying qualified wages if the farmer does not have enough QP to generate the full QBID allowed.

b. Conversely, a farmer that is below the applicable income threshold derives a larger QBID by not paying qualified wages, or by paying qualified wages in an amount such that half of the wages paid is less than 9% of the farmer’s Schedule F income that is attributable to the cooperative.

I.R.C. §199A Questions, Answers and Commentary

Thoughts on Rental Activities A rental activity is just that - an activity. It may rise to the level of an I.R.C. §162 trade or business, or it may not. When determining if a rental activity rises to the level of a trade or business, regular and continuous activity is needed, as is an intent to make income or profit. The preamble to the final regulations sets forth multiple factors to consider - one factor is how many rental activities the taxpayer has. Simply by virtue of having multiple properties, it may allow all of a taxpayer’s rental activities to rise to the level of a trade or business. This is NOT a formal grouping or aggregation – there is no need to formally group or aggregate rental activities to determine if they rise to the level of a trade or business. The final regulations also provide a rental safe harbor. The safe harbor is simply a mechanism that says if certain requirements are met, the rental activities qualify for §199A. It is important to remember that the level of the requirement in the safe harbor does not impact the trade or business determination. This has been determined by case law over the last 70 years and the TCJA did nothing to change it. For purposes of the safe harbor only, a taxpayer can place rental activities into “rental real estate enterprises” or RREEs. A RREE needs to meet the 250-hour test to meet the safe harbor. The safe harbor is entirely optional, and rental activities can easily fail the safe harbor but still rise to the level of an I.R.C. §162 trade or business. Putting rental activities in a RREE only matters for the safe harbor and has no impact on any other tax law provision.

Activities under I.R.C. §469 can be “grouped” so that it is more likely to meet the material participation test. This grouping has no impact on I.R.C. §199A. There is no “grouping” in I.R.C. §199A. But, there is aggregation. Under the final regulations, an individual or pass-through entity can choose to aggregate certain trade or business activities. The business activities must be related and meet other criteria. If activities are aggregated, the I.R.C. §199A deduction is computed as if the activities were a single activity. Thus, there are multiple ways to look at rental activities:  Aggregations – electing to treat all rental activities as a single activity.  RRRE – the term used when referencing the optional safe harbor and determining whether rental activities should be placed in one or more RRREs for safe harbor purposes.  Trade or business – determining whether a rental activity (or activities), as a whole, collectively rises to the level of a trade or business.

Q1: What is the point of the safe harbor? It is complicated, and it seems a lot of rentals will qualify on their own merit without it. Most safe harbors seem to make things easier. This one doesn’t. A1: The point is that people asked for one after the proposed Regulations were issued and they got it. Also, the IRS set the hour requirement of the safe harbor sufficiently high such that it can be fairly certain that anything that qualifies for the safe harbor wouldn't bear looking at. Thus, the IRS is putting the burden on tax preparers to document the facts & circumstances -- or face penalties. Q2: Is the RREE an election for purposes of the safe harbor only? I have been reading about this and am confused.

A2: It’s not an election. It’s an arrangement of properties, and it only applies to the safe harbor.

Q3: I have an S Corp client that is showing a $16,234 loss this year. She is considering closing the business. I’m unclear the QBI effect the loss will have in future years if the business closes. Could I please ask for guidance?

A3: The negative QBI will carry forward and offset future QBI.

Q4: I am preparing an S-corp "X" that is not an SSTB. There are three shareholders, A, B and C. A owns 50%, draws a salary, manages the business full-time, and is also my client. B owns 255 and, though not "silent", he is not active in the business and does not take any salary. However, B is the 100% owner of another entity, Y, that is a customer of X. Neither B nor Y are my clients. Shareholder C owns 25%, is the spouse of shareholder B, draws no salary, and is not involve. The S corporation operates a trade or business.

A4: You are required by the regulations to allocate all I.R.C. §199A items to the shareholders on the K-1. If B and C are passive, and the loss is suspended, then no QBI impact on them in 2018.

Q5: A commercial rental LLC (1065) has two tenants: one tenant is a trade or business that has >50% common ownership with the LLC. The second tenant is triple net lease with no common ownership in the LLC. The LLC only keeps one set of books. Is all the LLC rental income QBI?

A5: I would say “yes.” The 50 percent commonly controlled would be an SSTB if the commonly controlled business is an SSTB.

Q6: Is there any reason why the QBI income from a partnership K-1 shouldn't be limited to the phase out range for a MFJ taxpayer with a taxable income (pre-QBI) of $346,000? I was under the impression that it should phase out just like the schedule C QBI income, but it is not in my software. I want to double check the treatment before I figure out how to manipulate this. Anyone else deal with this in Lacerte?

A6: If you are over the $315,000 (joint), the SSTB and wage/property limitations begin to apply. However, if there is sufficient wages/property, the taxpayer still receives a full QBID. The SSTB limitation ratably reduces QBI, wages and UBIA over the phase-in range. If the partnership is not an SSTB, there is no phaseout.

Q7: I have a QBID Self-Rental situation that's driving me crazy: two MMLLC's (A&B) with same ownership. LLC A owns building and only exists to rent to LLC B. LLC B is a trade or business. Under Prop. Tres. Reg. §1.199A-4(b)(1)(i), LLC A is also treated as a trade or business due to common control. My problem is that I'm finding conflicting information on whether, or not, the two MMLLC's also have to meet the 4 requirements under Prop. Tres. Reg. §1.199A-4 (Business Aggregation), regardless if they actually aggregate. They meet the first 3 requirements, but the 4th requires meeting 2 of 3 conditions. I don't think they can meet 2. I would appreciate any help.

A7: Don’t worry about the proposed regulations. You have to meet two of the three tests to aggregate them for computational purposes.

Q8: I have a client that owns a hospital through a separate real estate entity and has a triple net lease with a separate operating company. Common ownership of more than 50 percent of the two companies is present. The real estate company would be eligible for QBID, correct? The operating company being in health would have no bearing on real estate company taking the QBID, correct?

A8: If the commonly controlled rental is rented to an SSTB, then the rental is deemed to be an SSTB.

Q9: I have a client who has two separate entities. One that operates a car wash and a separate entity that leases employees to the car wash. For purposes of the QBID, would the payroll lease expense qualify as W2 wages for the car wash? The employee leasing entity basically zeros out at year end with zero profit.

A9: Yes, professional employer organization (PEO) wages count as wages for I.R.C. §199A. Consider an aggregation election, however the wages are common law wages of the car wash business.

Q10: It's been a long day...but is Lacerte just screwing with me or am I mistaken? I have a client with two rental properties. A has a profit of $1700, property B has a loss of $1400. Both properties have passive losses from 2017 and prior but those shouldn't offset QBI for this year to my understanding. When I tell Lacerte that both properties are a trade or business, Lacerte then calculates QBI as $1700 and completely ignores the loss of $1400, even though it shows property B on the worksheet. Is the software wrong or am I mistaken about the netting rules?

A10: If property A has 2018 net income of $1,700 and property B has a 2018 loss of $1,400, then QBI is $300 and the deduction is $60 assuming that there is sufficient taxable income.

Q11: When would different entities be aggregated?

A11: When they qualify, aggregate. Also, aggregate when you have income in one entity and no wages or UBIA and the other entity has extra wages or UBIA. But, remember, once you aggregate, there is no going back.

Q12: I am confused between what is an I.R.C. §199A business and what is an SSTB.

A12: All trade or businesses are eligible for I.R.C. §199A. Some specified businesses are limited depending on income, wages or assets. Other service businesses are phased out based on whether they are included in a very specific list. But, all are eligible. Q13: Do you agree that the QBID safe harbor can't be used by a partnership that rents to a commonly controlled C corporation? I don't think it is available in that situation and that common control doesn't get you there either.

A13: Yes. However, Treasury and the IRS really should include C corporation operating entities in the deemed trade or business status of Reg. 1.199A-1(b)(14). Treasury and IRS already admit that the trade or business can be managed and operated across legal entity boundaries. The small business that chooses to operate as a C corporation should not be viewed different from the small business that operates an S corporation, when it comes to leasing real estate to that business. I understand that the real estate can’t be aggregated with a C corporation, but there is no reason, policy or otherwise, to deny the rental as trade or business treatment when that lease is to a commonly owned C corporation.

Q14: I am confused about the regular and continuous requirement as it applies to rentals. Can you help clarify?

A14: Some have showed concern that one-two hours a month of activity is insufficient to rise to a trade or business level. However, think about this: let’s imagine I am a part-time

consultant. I bill $300 per hour. Let’s say I do two hours per month in consulting work, totaling $7,200 a year. I just stick the cash in my personal bank account but keep a spreadsheet. Perhaps, most practitioners would treat that as a business activity and put the income on Schedule C subject to SE tax. If that’s the case, why would a rental be different (minus Schedule C and SE tax)?

Q15: I have several clients that are planning to replace their W-2 income with rental income in the next 2-10 years. What should I be doing to help them justify the rental income as QBI

A15: Create a formal business plan. Make a “duck” look like a “duck.”

Q16: Given the recent IRS FAQ and Q and A 33 in that document, do you recommend amending the tax returns if did not reduced QBI by SEHI for S Corp owners?

A16: No.

Q17: My client owns horses that pays a professional trainer to train her horses (and herself) to compete in horse shows. She is trying to build a reputation for the horses so she can profit from their offspring or sell them for a better price. Is this an SSTB in the field of performing arts? It seems like the shows are a type of performance and entertainment so I’m thinking it probably is. In this case, there is a loss for last year. If it is an SSTB, the loss won’t reduce QBI for another business that isn’t a SSTB. However, it will reduce QBI because of netting if it isn’t considered to be a performing arts business. The client has another business that is not an SSTB, so if the horse shows are not an SSTB, the loss will net against the profit from the other business and reduce the QBI. So, being an SSTB would result in a larger QBID.

A17: I am not sure. I am not comfortable saying that it is an SSTB. This assumes, of course, that the activity is not a hobby. The I.R.C. §199A guidance, to the extent it exists, doesn’t really address this question. You could take the position that it is, and also attach Form 8275 and let the IRS sort it out. I would certainly do that if you take the position that it is not an SSTB. Is there an underlying profit motive? Often, horse shows and rodeos are a way to market the client’s horses for sale with a win in competitions used as a means to increase the sales price of offspring from the winners. Bottom line, however, I think it’s more likely an athletic competition. Participants compete for prizes and points, etc. It’s either an athletic competition or nothing. “Reputation and skill” don’t necessarily mean what you may think it means. Professional horse trainers are animal trainers. They are not performers. Thus, there isn’t anything based on reputation (as described in the regulations). Again, bottom line for me is that it’s not an SSTB.

Q18: My client owns a rental property but uses a management company to operate it. Thus, I am thinking that the rental activity is not a trade or business. The property generates about $3,000. The client also receives a K-1 with a passive loss of $10,000. So, the passive loss can offset the passive income. My question is whether the $3,000 of income reduces the QBI loss carryforward of $10,000. I am thinking that this rental activity is not a trade or business.

A18: Use of a management company has very little to do with whether the activity is an I.R.C. §162 trade or business. If the client is renting it at market rate with the intent to make a profit it’s probably QBI, positive or negative. The fact that a management company is used is not determinative on the trade/business issue for QBID purposes. Remember, under the passive loss rules, rents are per se passive unless the real estate professional test is satisfied or material participation (or active participation) is present. But, that is a separate question from whether the activity is a trade or business for QBID purposes. I.R.C. §469 active/material participation is not relevant to whether the activity rises to the level of a §162 trade or business, which is what matters when determining whether it qualifies as QBI. It is easy to conflate the two or claim that one must meet the safe harbor requirement to qualify as QBI, but that is not true. In many respects, I believe that you will find the safe harbor to be useless because it is far easier to meet the I.R.C. §162 standard and it doesn't come with the draconian recordkeeping requirements (and signature under penalty of perjury) that the safe harbor does.

Q19: I have a client that is the sole shareholder of an S corporation. The S corporation has a loss this year. If I am understanding correctly, the client can take the loss on his personal return (if he has basis) and have a QBI loss carryforward as an NOL?

A19: A QBI loss carryforward is not the same as an NOL. A QBI loss (QB) will reduce future QBI. You can have an NOL carryforward, a suspended passive loss carryforward and a QBI loss carryforward. They are all computed independently and operate separately.

Q20: Do royalties that are received presently for the authorship of a book 10 years ago qualify for the QBID?

A20: Well, first of all, look at the reporting. Royalties from works that the taxpayer produced are reported on Schedule C (Bernie Sanders got it correct on his returns, Cory Booker did not). Royalties that are received due to having purchased, inherited or being “gifted” the rights to the work are reported on Schedule E. The IRS has ruled that an individual who writes only one book as a sideline and never revises it is not regularly engaged in an occupation or profession, and the book royalties are not considered earnings from self- employment. However, preparing new editions of the book and writing other books and materials reflect the conduct of a trade or business. Thus, a full-time professor who co- authors a textbook and does not engage in any other commercial authorship work while writing the textbook and has no obligation to work on future editions is not engaged in a trade or business. Even though an individual is retired and not currently involved in his or her creative pursuit of income, any royalties received are business income if the individual was engaged in the business at the time the material generating the royalties was produced. In summary, royalty income should be classified as business income for individuals who were in the business at the time the intellectual property was created.

Q21: Does a loss for 2018 that is disallowed under I.R.C. §469 mean that the loss hasn’t yet occurred for I.R.C. §199A purposes?

A21: Generally, yes. However, there is still debate as to pre-2018 suspended passive losses that are freed up in 2018 or later. My reading of the applicable regulation is that these clearly

do not affect QBI, yet many software providers are programming that they do. Thus, a suspended 2018 rental loss under I.R.C. §469 doesn’t reduce QBI until it is released under I.R.C. §469. To restate, a pre-2018 suspended loss does not reduce QBI in a later year.

Q22: I have a client with a K-1 showing passive self-rental income. He is a full-time owner of a construction business. He uses his shop for equipment, etc. He likely does not spend 250 hours annually on the rental activity. No QBI?

A22: For starters, 250 hours doesn’t matter if the activity meets the commonly controlled entity rule. If that is the case, it will automatically qualify regardless of being an I.R.C. §162 trade or business. If that is not the case, then the question becomes whether the activity constitutes a trade or business under I.R.C. §162. Remember, the self-rental income is only passive (if it’s a loss) for I.R.C. §469 purposes. If it’s income, it cannot be used to offset other passive losses.

Q23: I have two K-1's coming into the personal return with about $500,000 total. The client sold a residential rental. On the client’s personal return, that released about $50,000 in prior year carryforward passive losses that offset the Schedule E income of $500,000 for income tax purposes. But that does not reduce the QBI, right? They should (and are) getting the QBID on the $500,000 K-1 income. Since it was not a trade or business loss, it shouldn't affect QBI? From what i think I understand, pre-2018 losses do not affect 2018 QBI, but want to make sure.

A23: Pre-2018 suspended §469 losses from a qualified trade or business do not reduce QBI when later released.

Q24: Does the income from the lease of land for a cell tower qualify for the QBID?

A24: It depends, but it is unlikely. Does the taxpayer mow or maintain weed control? Does the company have fencing around their equipment? Does the taxpayer do anything other than collect a rent check and sign a new lease every few years upon expiration of the old lease?

Q25: When are oil and gas royalties not eligible for the QBID? I have a trust that holds many oil and gas interests/leases directly. The 1099-Misc. reports the income in Box 2-Royalties and Box7-Nonemployee compensation.

A25: Generally, that activity does not rise to an I.R.C. §162 trade/business activity. But, Box 7 reporting seems to indicate that there is some working interest ownership involved. You may want to dig into that a bit deeper. The royalty portion would go on Schedule E, the working interest portion would go on Schedule C.

Q26: Can commercial real estate be aggregated with residential real estate? I know you can’t put them together under the 250-hour safe harbor, but what about for “plain old” aggregation?

A26: I assume you are referring to aggregation under Treas. Reg. §199A-4. If so, then I see no reason why you couldn’t if the requirements are met. While Example 17 in this regulation concludes that you can’t aggregate commercial and residential real estate, that conclusion

is based on the facts and circumstances of the example. In that example, the fact that one was residential and the other was commercial meant that they couldn’t meet two of the three fact-based tests. However, there is no specific prohibition. However, I think it would be hard to satisfy the requirements in most situations.

Q27: In addition to 1/2 SE and SEHI, does a contribution to a traditional IRA have to be deducted from QBI?

A27: Nothing definitive. Probably not, barring further guidance. IRAs are based on earned income, not only self-employment income.

A28: I have a client who is a limited partner in a family limited partnership that rents farm land. There is QBI info on the K-1. Does that mean they have determined it is QBI eligible for the partners? Or do I need to inquire about any NNN lease scenario? It seems to be a very large partnership as my client's income is $31,000 with only an 8 percent interest.

A28: If QBI is determined at the entity level all partners can take it, subject to it being tested at the owner’s level. It's just like the info in Box 1 or 2 - you roll with it unless you disagree and want to file the forms to report something different. I'd say go. They should know at the entity level what's happening.

Q29: For 2018, my client was an active partner in a partnership. In 2018, the partnership filed a FINAL return with a large loss. After factoring in basis, etc., the client is eligible to claim some of the loss on his 2018 Form 1040. Will this loss carry forward and count against future I.R.C. §199A gains, thus limiting the deduction in future years?

A29: Yes. Q30: I have a client that purchased a new residence in January 2018. But there was a rental that had to be completed thru July 31st. Is that rental income QBI? I'm thinking not since they really weren't in this to make a profit. A30: I’d say “no.” Q31: Does I.R.C. §1245 recapture that is incurred on the sale of real estate get included in QBI? A31: Yes. Q31: An MMLLC owns rental real estate leased out on a triple net lease. On the K-1 do I indicate it's QBI and disclose NNN status so that each partner can discuss treatment with their CPA? Or do I not complete QBI fields?

A31: The partnership makes the determination. It is conducting the activity.

Q32: I realize we have to account for the SE Health Deduction when determining QBI. My question is whether the taxpayer can elect NOT to take the SEHI deduction and instead take the entire deduction on Sch A as a medical expense? My client already has enough medical before the premiums to get over the 7.5% threshold. They are in the 12% tax bracket and if I elect to take the insurance premiums on Sch A instead of as an adjustment

to income then the tax benefit of the QBI deduction is enhanced and their overall tax is decreased. I've looked at Sec 162I and can't see anything requiring the TP to take the adjustment instead of the Sch A deduction. It merely states if taking it as an adjustment you can't double dip on the Sch A. Thoughts?

A32: Interesting planning idea. I don’t see anything that prohibits doing this. However, you may want to check what the impact might be on the state return.

Q33: Here is my current dilemma. For QBI reporting can a taxpayer include the unadjusted basis of assets that were not originally capitalized (under capitalization policy)? Everything I read leads me to believe "no" but I can't find definitive guidance and my client is adamant about including uncapitalized assets.

A33: You just have to work through the interaction of section 1.263(a)-1(f) and the section 199A regs. Unless the assets are subject to depreciation they not qualified property. If an asset is expensed, it is not eligible for depreciation. But if an asset is not capitalized I don’t see how it can be treated as qualified property.

Q34: 1120s Health Insurance Question: Shareholder's (>2%) health insurance is reimbursed by the corporation and that amount is listed in Box 1 of his W-2 in addition to his regular wages. My question: should the health insurance portion be listed on 1120s Line 7 and feed into the total QBI Wage amount or another 1120s deduction line (insurance, employee benefit) and not feed into the total QBI Wage amount? My understanding is that using the unmodified box method should exclude the health insurance from the QBI Wage amount (since the health insurance is not listed in Box 5 of the W2), therefore the health insurance portion should not be listed on 1120s Line 7.

A34: QBI wages are determined by the W-2s and computed using the relevant IRS Notice - not relevant to how you list it on tax return

Q35: Is there any guidance from the IRS on how to handle the transition cooperative payments? A35: No. Even if we get the guidance now, the tax software would not be ready by April 15. So, if the return hasn’t been filed yet and the client has a material amount of cooperative receipts, it might be best to put the return on extension. Q36: My client received an IRS notice requesting additional information on how taxable income was computed. Apparently, the IRS computers couldn’t match taxable income on Form 1040 to what was shown on the return. I am able to determine that the issue stems from the IRS instructions that say a cooperative DPAD is to be reported as a deduction directly on line 10 (taxable income) of Form 1040. How do I handle this?

A36: The instructions do not tell you attach any type of worksheet showing how the number is arrived at, but simply subtract that number from other taxable income. The problem is that the Form 1040 does not match, and the IRS computer can’t add and subtract to the correct amount of taxable income, even though the IRS instructions say the return is to be prepared

in this manner. You will have to write individual letters to the IRS to explain how taxable income is computed.

Q37: Where on the return do I include the deductions for amounts attributable to the DPAD and QBID that is being passed through from an agricultural cooperative?

A37: A DPAD that is received (as part of the cooperative transition rule), will be reported as a deduction on line 36 of Schedule 1. There is no separate line for the deduction, it is simply added into the number shown on line 36 as adjustments to income. Second, if you receive an I.R.C. §199A DPAD, it will simply show up as a reduction to taxable income on line 10 of Form 1040. Again, there is no separate form or line for this deduction to be reported on. It is not added to the I.R.C. §199A(a) deduction reported on line 9 of Form 1040. It simply reduces taxable income and your tax software will write in “Section 199A DPAD” or words to that affect and likely not show any deduction amount. This means your Form 1040 will not match. The I.R.C. §199A deduction is calculated on the worksheets provided by the IRS and really have nothing to do with either the DPAD or the QBI/DPAD.

Q38: I have a farm client that sells to a cooperative, but also has another business that produces a loss. In this situation, how is the adjustment to be made to the final QBID?

A38: The adjustment is the lesser of 9 percent of QBI that is related to cooperative receipts or 50 percent of wages related to the same income. But, the loss from the other business will need to be netted against the positive QBI on a pro-rata basis. So, adjust the cooperative QBI to a net number before you do the 9 percent/50 percent calculation. For example, assume the 9 percent/50 percent computation on the cooperative receipts is $15,000. Also, assume that the client’s Schedule C business loses $80,000 and that net QBI is $50,000 and the gross QBID is $10,000. If the $15,000 is subtracts from the gross QBID, it’s negative – which you can’t have. But, if you allocate the loss to the cooperative-derived income, and then multiply that amount by the lesser of the 9 percent/50 percent calculation the result will be a positive QBID – plus any amount passed through from the cooperative. But a caveat – there is no guidance from the IRS on this.

Q39: Do I limit the amount that I reduce QBI by to the amount that is deducted against taxable income? In other words, I don’t create a loss carryforward by deducting the full amount of self- employed health insurance paid even if I was limited in what I can deduct when calculating taxable income.

A39: You are correct. Only reduce QBI by the deduction that is allowed on the return.

Q40: My client has income from grain sales sold in the prior fiscal year. That amount makes up 40 percent. He also has income after the fiscal year end that makes up 60 percent. Do I only deduct 60 percent of the s.e. tax and 60 percent of the s.e. health insurance?

A41: You are correct. The 40 percent of s.e. health insurance before the fiscal year-end is not deducted against QBI. This is the approach that you take whenever have QBI and non- QBI income – allocate between the QBI and non-QBI portions.

Q42: My client sold assets on which he had taken I.R.C. §179 depreciation. How do I report the effect on QBI on Schedule K-1? Does it increase QBI because it is §1245 gain?

A42: You are correct that the gain from the sale of assets that is attributable to expense method depreciation has been claimed will be QBI. I am assuming that the assets sold were trade/business assets. Why don’t you put a footnote on Schedule K-1 indicating that the gain from the sale of the assets may increase QBI if it is determined that there is a gain at the owner level. Don’t reduce QBI for the expense method amount shown on the K-1. You don’t know yet if the owner will be able to deduct the expense. That’s why you will need to put a footnote that indicates that you might reduce QBI if it is later determined to be allowed at the owner level.

Q43: My client received 1099s from the cooperative and they don’t show any per unit retains. The cooperative didn’t pass through any DPAD. How do I know what was done on the cooperative’s side? The 1099s show patronage dividends only. How do I adjust the QBID?

A43: You will need to ask the cooperative your questions. You need to find out what their year- end is and how much of the payments were used to calculate the DPAD for the fiscal year- end 2018 tax return under I.R.C. §199.

Q44: My client sells grain to a cooperative that didn’t pass through any DPAD in either 2017 or 2018. Does the client still separate out his sources of income? If he didn’t receive and DPAD, does he still reduce his sales to the cooperative by 9 percent or not?

A44: It doesn’t matter whether the cooperative passes through any DPAD. The client still needs to account for the grain sales if the cooperative used them in calculating its DPAD.

Note: The following are various blog posts of Prof. McEowen on the I.R.C. §199A statute, proposed and final regulations and the draft proposed regulations covering agricultural cooperatives and patrons. The blog is the Agricultural Law and Taxation blog and is accessible via the homepage of washburnlaw.edu/waltr.

Monday, January 15, 2018 The Qualified Business Income (QBI) Deduction – What a Mess! By Roger A. McEowen Overview If tax simplicity was the goal of the recently enacted “Tax Cuts and Jobs Act” (not the official title), it’s hard to claim that the goal was met, at least as to the entirety of the bill. Perhaps a number of the individual income tax provisions were streamlined by virtue of the elimination of some itemized deductions and the near doubling of the standard deduction. Likewise, the corporate tax rate structure was simplified by moving to a single 21 percent rate. But that single lower rate doesn’t necessarily mean that there will be a stampede to form C corporations or convert existing businesses to C corporate status. There are other issues that work against converting a business to the C corporate form.

For sole proprietorships and pass-through businesses, a new deduction makes tax planning and preparation more complex - much more complex. Today’s post takes a brief look at this new deduction – a 20 percent deduction for qualified business income (QBI) that is available to businesses other than C corporations. There are many issues associated with the QBI, and those issues will be left for future posts. But, a couple of implications are addressed in this post. The QBI Deduction The complexity of the QBI deduction Code section (I.R.C. §199A) is difficult to overstate. The new QBI provision is 23 pages in length, at least when counting pages of the text of the provision in the final bill version that the President signed. If my count is correct, there are over 20 definitions in §199A, more than two dozen cross references to other parts of the Code, and just as many cross-references to other parts of §199A. The QBI deduction computation contains several formulas with “lesser than” or “greater than” language, and some of the computations are embedded inside each other. In addition, those computations involve addition, subtraction and multiplication (remember the ordering rules from grade school math class?). The QBI deduction also includes exemption amounts, formulas that phase-out those exemptions, and an international tax provision that applies to domestic pass-through entities. The basics. The genesis for the §199A deduction dates at least to 2009. Before he became House Majority Leader in 2011, Rep. Eric Cantor, proposed a 20 percent deduction for small businesses. That proposal came up again a couple of times in later years, but nothing was formally introduced until the tax legislative discussions started to take shape in the summer of 2016, and the legislative process unfolded in 2017. The 20 percent deduction found its life in newly created I.R.C. §199A as part of the recently enacted tax bill. Like the original proposal years ago, the QBI deduction is a deduction against business income for non-C corporations that aren’t specified service businesses. Some of the other basic points about the QBI deduction include: 1) for income above a threshold a W-2 wage limitation applies; 2) the deduction is claimed at the partner or shareholder level; 3) trusts and estates are eligible, as are agricultural and horticultural cooperatives; 4) the deduction applies only for income tax purposes, and is determined without regard to alternative minimum tax (AMT) adjustments; and 5) the accuracy-related penalty for substantial understatement of tax for a tax return claiming the QBI deduction applies if the understatement if five percent, rather than the normal 10 percent. The formulas. The QBI deduction equals the sum of the lesser of the “combined qualified business income” of the taxpayer, or 20 percent of the excess of taxable income over the sum of any net capital gains and qualified cooperative dividends, plus the lesser of 20 percent of qualified cooperative dividends or taxable income less net capital gain. What is “combined qualified business income”? It’s not really income. Instead, it’s a deduction. It’s 20 percent of the taxpayer’s “qualified business income” from each of the taxpayer’s qualified trade or business; limited to the greater of 50 percent of W-2 wages with respect to the business or 25 percent of the W-2 wages with respect to the business, plus 2.5 percent of the unadjusted basis (immediately after acquisition of all qualified property). Plus, 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income. Definitions. As noted the definition of terms for purpose of the deduction are many. “Qualified property” is defined as tangible property that is subject to I.R.C. §167 depreciation. Likewise, “qualified business income” is the taxpayer’s ordinary income (less ordinary deductions) from the taxpayer’s non-C corporate business. Not included are any wages earned as an employee. Thus, for independent contractors, self- employment income is QBI that is potentially eligible for the 20 percent deduction. Conversely, for employees, wages earned are not eligible for the 20 percent deduction. Also, the definition of QBI does not include short or long-term capital gain or loss, dividend income or interest income. In addition, QBI does not include any wages or guaranteed payments received from a flow-through business, and any income that is not “effectively connected with the conduct of a U.S. trade or business.” QBI might also include rental income. Clearly, the QBI must be earned in a “qualified trade or business.” But, what definition is going to be used to determine “trade or business”? My guess is it will be the I.R.C. §162 definition. If so, certain rental activities may not meet the definition, such as a triple-

30 net lease where the owner has practically no regular involvement. Also, not satisfying the test would be cash rentals and non-material participation crop-share or livestock-share leases. As noted above, the formula applies a W-2 wage limitation to pass-through businesses and sole proprietorships. However, the limitation does not apply to taxpayers below $315,000 (MFJ) – half of that for all other filers. Once taxable income exceeds the threshold, the W-2 limitations are phased-in over the next $100,000 of taxable income (MFJ) - $50,000 for all other taxpayers. But, what are W-2 wages? They must be wages subject to withholding. So, by definition, that excludes payments a business makes to an independent contractor, management fees that are paid, and ag wages paid in-kind. However, wages paid to children under age 18 by parents count as qualified wages. How so? I.R.C. Sec. 199A(b)(4)(A) references I.R.C. Sec. 6501(a) for the definition of W-2 wages. In particular, I.R.C. Sec. 6051(a)(3) specifies that the total wages are defined in I.R.C. Sec. 3401(a) which is the definition of wages for withholding purposes. The I.R.C. §3401(a) definition comprises all wages, including wages paid in a medium other than cash, except wages paid for agricultural labor unless the wages are for payroll tax purposes under I.R.C. §3401(a)(2). Wages paid to children under age 18 by their parents are not included as an exception in IRC §3401(a). Such wages are subject to withholding but are often exempt because the amount is less than the standard deduction. However, under IRC §3401(a)(2), commodity wages are not included because they are not “wages” under IRC §3121(a). Therefore, wages paid to children under age 18 by their parents count as wages for QBI purposes, but agricultural wages paid in-kind do not. In addition, the wages must be paid for amounts that are properly allocable to producing QBI. Net Operating Losses. As for net operating losses (NOLs), if a taxpayer claims the QBI deduction in the same year as an NOL, the deduction does not add to the NOL. Agricultural and horticultural cooperatives. One issue that Senators Thune (R-SD) and Hoeven (R- ND) (among others) are presently working on is a technical correction that would balance out how the QBI deduction works with respect to agricultural products sold to a cooperative by a patron and those sold to a non-cooperative. A cooperative is eligible for the QBI deduction in accordance with a formula (of course). That is not in controversy. A cooperative’s deduction is 20 percent of the cooperative’s excess gross income over qualified cooperative dividends, or the greater of 50 percent of the cooperative’s W-2 wages, or the sum of 25 percent of the cooperative’s W-2 wages relating to the cooperative’s business plus 2.5 percent of the unadjusted basis immediately after acquisition of the cooperative’s qualified property. The deduction is then limited to the cooperative’s taxable income for the tax year. What is controversial is that the QBI deduction is essentially 20 percent of taxable income (less capital gains) in the hands of a taxpayer that is a patron of a cooperative that sells to the cooperative. For a taxpayer in the 35 percent bracket, the deduction would reduce the effective rate by seven percentage points. However, for a taxpayer that doesn’t sell the ag products to a cooperative (say, for example) to a private elevator, the deduction is 20 percent of net farm income. That will often result in a lower deduction, but whether a sale should be made to a cooperative or a non-cooperative will depend on various economic factors as well as the tax factors. The discrepancy could cause some farm landlords to switch from a cash lease to a crop-share lease if doing so will allow the landlord to claim the QBI deduction. Sales to a non-cooperative require that the taxpayer be engaged in a “trade or business” to qualify for the deduction. That means that a cash rent landlord will not qualify for the deduction. On the other hand, sales to a cooperative do not require the existence of a trade or business. Thus, the tenant under a cash lease gets the entire deduction. The landlord under a crop-share lease would be entitled to the landlord’s share. Form 4797 and the QBI Deduction Even though the new tax bill bars personal property trades, farmers will undoubtedly continue “trading” equipment. The “trade-in” value will be listed as the “selling price” of the “traded” equipment. A key question is whether the gain reported on Form 4797 will be QBI. As noted, the QBI deduction does not

31 apply to capital gain income. I.R.C. §199A refers to “capital gain.” It does not refer to “gain on capital assets.” Thus, income taxed as “capital gain,” even though it is from an I.R.C. §1231 asset, is included in the definition of “capital gain” that is not eligible for the QBI deduction. Form 4797 separates out the I.R.C. §1231 gain, the ordinary income and the gain attributable to recapture from sales or exchanges of business property. Specifically, Form 4797 Part I property is includible as LTCG property (taxed at a favorable rate), and is not QBI. Form 4797 Part II property is not considered STCG property, which is specifically excluded from the calculation. Gain or loss reported on Part II is QBI. The same is true for income reported on Part III of Form 4797. The Form 4797 issue is not restricted just to personal property trades. It will also arise, for example, with respect to dairy operations. Dairies that are not C corporations, can be eligible for the QBI deduction. However, without careful planning, the deduction could be of limited value. Dairies typically have two sources of income – Schedule F income from milk sales (which is likely minimal due to offsetting expenses); and Form 4797 where sales of culled dairy cows are reported. The gain attributable to the dairy cow sales is not eligible for the QBI deduction. Conclusion I will get into more of the QBI-related issues at the law school’s January 24 seminar/webinar. Our first one on January 10 sold-out, and available spots for the January 24 event are filling up fast. Information on registration is available here: http://washburnlaw.edu/employers/cle/taxlandscape2.html. By the time we get to January 24, there may be additional developments concerning the QBI deduction, especially with respect to its application to cooperatives and patrons. In addition, Paul Neiffer and I will delve deeply into these issues at our summer seminar in Shippensburg, PA on June 7-8. Plan now to attend. Be watching http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/index.html for information concerning the seminar in the next few days. If you would like to be put on a list to be notified of the June seminar, please send an email to [email protected].

Monday, March 26, 2018 Congress Modifies the Qualified Business Income Deduction By Roger A. McEowen Overview Late last week, the Congress passed, and the President signed, the Consolidated Appropriations Act of 2018, H.R. 1625. This 2,232-page Omnibus spending bill, which establishes $1.3 trillion of government spending for fiscal year 2018, contains a provision modifying I.R.C. §199A that was included in the Tax Cuts and Jobs Act (TCJA) enacted last December and which became effective for tax years after 2017. I.R.C. §199A , known as the qualified business income (QBI) deduction, created a 20 percent deduction for sole proprietorships and pass-through businesses. However, the provision created a tax advantage for sellers of agricultural products sold to agricultural cooperatives. Before the technical correction, those sales generated a tax deduction from gross sales for the seller. But if those same ag goods were sold to a company that was not an agricultural cooperative, the deduction could only be taken from net business income. That tax advantage for sales to cooperatives was deemed to be a drafting error and has now been technically corrected. The modified provision removes the TCJA’s QBI deduction provision for ag cooperatives and replaces it with the former (pre-2018) I.R.C. §199 for cooperatives. In addition, the TCJA provision creating a 20 percent deduction for patronage dividends also was eliminated. Also, the modified language limits the deduction to 20 percent of farmers’ net income, excluding capital gains. The Joint Committee on Taxation estimates that the provision modifying I.R.C. §199A will raise $108 million over the next decade.

Today’s blog post examines the modification to I.R.C. §199A. The Domestic Production Activities Deduction In general. I.R.C. §199, the Domestic Production Activities Deduction (DPAD) was enacted as part of the American Jobs Creation Act of 2004 effective for tax years beginning after 2004. While often referred to as a “manufacturing” deduction, the DPAD was available to many businesses including those engaged in agricultural activities. Except for domestic oil-related production activities (for which the deduction is limited to six percent), for tax years beginning after 2009 and before 2018, the DPAD is equal to the lesser of 9 percent of the taxpayer’s qualified production activities income for the year; 9 percent of the taxable income of the taxpayer (for an individual, this limitation is applied to AGI); and 50 percent of the Form W- 2 (FICA) wages of the taxpayer for the taxable year. Former I.R.C. §§199(a)(1) and (b)(1). The deduction was from taxable income, subject to an overall limit of 50 percent of current year Form W-2 wages that were associated with qualifying activity employment. The DPAD was allowed for both regular tax and alternative minimum tax (AMT) purposes (including adjusted current earnings). However, it was not allowed in computing SE income, and it could not create a loss. Pass-Through Entities. In general, the DPAD was not claimed by pass-through entities (such as S corporations, partnerships, estates or trusts) when computing taxable income. Instead, the DPAD was applied at the shareholder, partner or beneficiary level. The pass-through entity would provide the necessary information required to compute the DPAD as a footnote on Schedule K-1. A taxable income limitation applied at the shareholder/partner level with each shareholder/partner separately computing the DPAD on its individual income tax return. Note: While the DPAD was not claimed by a pass-through entity, estates and trusts were eligible for the DPAD if the income was not passed through to the beneficiaries. Agricultural Cooperatives. Agricultural cooperatives could also claim the DPAD. However, the amount of any patronage dividend or per-unit retain allocations to a member of the cooperative that were allocable to qualified production activities were deductible from the member’s gross income. Members of agricultural cooperatives included the DPAD for their distributions from the cooperative. The rules for cooperatives provided in §199(d)(3) and Treas. Reg. §1.199-6 applied to any portion of the DPAD that is not passed through to the cooperative’s patrons. In addition, a cooperative’s qualified production activities income was 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. The TCJA Provision as Applied to Agricultural Cooperatives For tax years beginning after 2017, the DPAD is repealed. In its place, for taxable years beginning after December 31, 2017, and before January 1, 2026, the TCJA creates (as applied to an agricultural or horticultural cooperative) a deduction equal to the lesser of (a) 20 percent of the excess (if any) of the cooperative’s gross income over the qualified cooperative dividends paid during the taxable year for the taxable year, or (b) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. I.R.C. §199A(g). The cooperative’s section 199A(g) deduction may not exceed its taxable income (computed without regard to the cooperative’s deduction under I.R.C. §199A(g)) for the taxable year. As for the impact of I.R.C. §199A on patrons of ag cooperatives, effective for tax years beginning after 2017, there is no longer a DPAD that a cooperative can pass through to a patron. However, as noted above, the deduction is 20 percent of the total of payments received from the cooperative (including non-cash qualified patronage dividends). The only limit is 100 percent of net taxable income less capital gains. For sales to a non-cooperative, the deduction is 20 percent of net farm income.

The Modification Impact on cooperatives. The provision in the Omnibus bill removes the QBI deduction for agricultural or horticultural cooperatives. In its place, the former DPAD provision (in all practical essence) is restored for such cooperatives. Thus, an ag cooperative can claim a deduction from taxable income that is equal to nine percent of the lesser of the cooperative’s qualified production activities income or taxable income (determined without regard to the cooperative’s I.R.C. § 199A(g) deduction and any deduction allowable under section 1382(b) and (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions)) for the taxable year. The amount of the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the cooperative during the calendar year that ends in such taxable year. For this purpose, W-2 wages are determined in the same manner as under the other provisions of section 199A (which is not repealed as applied to non-cooperatives), except that “wages” do not include any amount that is not properly allocable to domestic production gross receipts. A cooperative’s DPAD is reduced by any amount passed through to patrons. Under the technical correction, the definition of a “specified agricultural or horticultural cooperative” is limited to organizations to which part I of subchapter T applies that either manufacture, produce, grow, or extract in whole or significant part any agricultural or horticultural product; or market any agricultural or horticultural product that their patrons have manufactured, produced, grown, or extracted in whole or significant part. The technical correction notes that Treas Reg. §1.199-6(f) is to apply such that agricultural or horticultural products also include fertilizer, diesel fuel, and other supplies used in agricultural or horticultural production that are manufactured, produced, grown, or extracted by the cooperative. Note: As modified, a “specified agricultural or horticultural cooperative” does not include a cooperative solely engaged in the provision of supplies, equipment, or services to farmers or other specified agricultural or horticultural cooperatives. Impact on patrons. Under the new language, an eligible patron that receives a qualified payment from a specified agricultural or horticultural cooperative can claim a deduction in the tax year of receipt in an amount equal to the portion of the cooperative’s deduction for qualified production activities income that is: 1) allowed with respect to the portion of the qualified production activities income to which such payment is attributable; and 2) identified by the cooperative in a written notice mailed to the patron during the payment period described in I.R.C. §1382(d). Note: The cooperative’s I.R.C. §199A(g) deduction is allocated among its patrons on the basis of the quantity or value of business done with or for the patron by the cooperative. The patron’s deduction may not exceed the patron’s taxable income for the taxable year (determined without regard to the deduction, but after accounting for the patron’s other deductions under I.R.C. §199A(a)). What is a qualified payment? It’s any amount that meets three tests: 1) the payment must be either a patronage dividend or a per-unit retain allocations; 2) the payment, must be received by an eligible patron from a qualified agricultural or horticultural cooperative; and 3) the payment must be attributable to qualified production activities income with respect to which a deduction is allowed to the cooperative. An eligible patron cannot be a corporation and cannot be another ag cooperative. In addition, a cooperative cannot reduce its income under I.R.C. §1382 for any deduction allowable to its patrons by virtue of I.R.C. §199A(g). Thus, the cooperative must reduce its deductions that are allowed for certain payments to its patrons in an amount equal to the I.R.C. §199A(g) deduction allocated to its patrons. Transition rule. A transition rule applies such that the repeal of the DPAD does not apply to a qualified payment that a patron receives from an ag cooperative in a tax year beginning after 2017 to the extent that the payment is attributable to qualified production activities income with respect to which the deduction is allowed to the cooperative under the former DPAD provision for the cooperative’s tax year that began before 2018. That type of qualified payment is subject to the pre-2018 DPAD provision, and

34 any deduction allocated by a cooperative to patrons related to that type of payment can be deducted by patrons in accordance with the pre-2018 DPAD rules. In that event, no post-2017 QBI deduction is allowed for those type of qualified payments. Conclusion With the technical correction to I.R.C. §199A, where do things now stand for farmers?

 The overall QBI deduction cannot exceed 20 percent of taxable income. That restriction applies to all taxpayers regardless of income. If business income exceeds $315,000 (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation test is phased-in.  The prior I.R.C. 199 DPAD no longer exists, except as resurrected for agricultural and horticultural cooperatives as noted above. The 20 percent QBI deduction of I.R.C. §199A is available for sole proprietorships and pass-through businesses. For farming businesses structured in this manner, the tax benefit of the 20 percent QBI deduction will likely outweigh what the DPAD would have produced.  While those operating in the C corporate form can’t claim a QBI deduction, the corporate tax rate is now a flat 21 percent. That represents a tax increase only for those corporations that would have otherwise triggered a 15 percent rate under prior law.  For C corporations that are also patrons of an agricultural cooperative, the cooperative’s DPAD does not pass through to the patron.  For a Schedule F farmer that is a patron of an agricultural cooperative and pays no wages, there are two steps to calculate the tax benefits. First, the cooperative’s DPAD that is passed through to the patron can be applied to offset the patron’s taxable income regardless of source. Second, the farmer/patron is entitled to a QBI deduction equal to 20 percent of net farm income derived from qualified non-cooperative sales, subject to the taxable income limitation ($315,000 MFJ; $157,000 all others).  For farmers selling to ag cooperatives that also pay W-2 wages, the QBI deduction is calculated on the sales to cooperatives by applying the lesser of 50 percent of W-2 wages or 9 percent reduction limitation. Thus, for a farmer that has farm income beneath the $315,000 threshold (MFJ; $157,500 all others), the QBI deduction will never be less than 11 percent (i.e., 20 percent less 9 percent). If the farmer is above the $315,000 amount (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation will be applied before the 9 percent limitation. This will result in the farmer’s QBI deduction, which cannot exceed 20 percent of taxable income. To this amount is added any pass- through DPAD from the cooperative to produce the total deductible amount.  For farmers that sell ag products to non-cooperatives and pay W-2 wages, a deduction of 20 percent of net farm income is available. If taxable income is less than net farm income, the deduction is 20 percent of taxable income less capital gains. If net farm income exceeds $315,000 (MFJ; $157,500 single), the deduction may be reduced on a phased-in basis.  The newly re-tooled cooperative DPAD of I.R.C. 199A may incentivize more cooperatives to pass the DPAD through to their patrons.

Monday, August 13, 2018 Qualified Business Income Deduction – Proposed Regulations By Roger A. McEowen Overview As a result of the Tax Cuts and Jobs Act (TCJA), for tax years beginning after 2017 and before 2026, a non C corporate business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20% of the taxpayer’s share of qualified business income (QBI) associated with the conduct of a trade or business in the United States. I.R.C. 199A. The QBID replaces the DPAD, which applied for tax years beginning after 2004. The TCJA repealed the DPAD for tax years beginning after 2017. The basic idea behind the provision was to provide a benefit to pass-through businesses and sole proprietorships that can’t take advantage of the lower 21 percent corporate tax rate under the TCJA that took effect for tax years beginning after 2017 (on a permanent basis). The QBID also applies to agricultural/horticultural cooperatives and their patrons. Last week, the Treasury issued proposed regulations on the QBID except as applied to agricultural/horticultural cooperatives. That guidance is to come later this fall. The proposed regulations did not address how the QBID applies to cooper The proposed regulations for the QBID – that the topic of today’s post. QBID Basics The QBI deduction (QBID) is subject to various limitations based on whether the entity is engaged manufacturing, producing, growing or extracting qualified property, or engaged in certain specified services (known as a specified service trade or business (SSSB)), or based on the amount of wages paid or “qualified property” (QP) that the business holds. These limitations apply once the taxpayer’s taxable income exceeds a threshold based on filing status. Once the applicable threshold is exceeded the business must clear a wages threshold or a wages and qualified property threshold. Note: If the wages or wages/QP threshold isn’t satisfied for such higher-income businesses, the QBID could be diminished or eliminated. What is the wage or wage/QP hurdle? For farmers and ranchers (and other taxpayers) with taxable income over $315,000 (MFJ) or $157,500 (other filing statuses), the QBID is capped at 50 percent of W-2 wages or 25 percent of W-2 wages associated with the business plus 2.5 percent of the “unadjusted basis immediately after acquisition” (UBIA) of all QP. But those limitations don’t apply if the applicable taxable income threshold is not met. In addition, the QBID is phased out once taxable income reaches $415,000 (MFJ) or $207,500 (all others). Proposed Regulations On August 8, the Treasury issued proposed regulations on the QBID. Guidance was needed in many areas. For example, questions existed with respect to the treatment of rents; aggregation of multiple business activities; the impact on trusts; and the definition of a trade or business, among other issues. The proposed regulations answered some questions, left some unanswered and raised other questions. Rental activities. One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI. The proposed regulations do confirm that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s the case if the rental is between “commonly controlled” entities – defined as common ownership of 50 percent or more in each entity (e.g., between related parties). This

36 part of the proposed regulations is generous to taxpayers, and will be useful for many rental activities. It’s also aided by the use of I.R.C. §162 for the definition of a “trade or business” as opposed to, for example, the passive loss rules of I.R.C. §469. But, the proposed regulations may also mean that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID. If that latter situation is correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID. The proposed regulations use an example or a rental of bare land that doesn’t require any cost on the landlord’s part. This seems to imply that the rental of bare land to an unrelated third party qualifies as a trade or business. There is another example in the proposed regulations that also seems to support this conclusion. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. That means it may be crucial to be able to aggregate (group) those activities together. Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations creates confusion. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162. But, the Preamble also states that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, does that mean that those separate rental activities can’t be aggregated (discussed below) unless each rental activity is a trade or business? If the Treasury is going to be making the trade or business determination on an entity-by-entity basis, triple net leases might be problematic. Perhaps the final regulations will clarify whether rentals, regardless of the lease terms, will be treated as a trade or business (and can be aggregated). Aggregation of activities. Farmers and ranchers often utilize more than a single entity for tax as well as estate and business planning reasons. The common technique is to place land into some form of non C corporate entity (or own it individually) and lease that land to the operating entity. For example, many large farming and ranching operations have been structured to have multiple limited liability companies (LLCs) with each LLC owning different tracts of land. These operations typically have an S corporation or some other type of business entity that owns the operating assets that are used in the farming operation. It appears that these entities can be grouped under the aggregation rule. For QBID purposes (specifically, for purposes of the wages and qualified property limitations) the proposed regulations allow an election to be made to aggregate (group) those separate entities. Thus, the rental income can be combined with the income from the farming/ranching operation for purposes of the QBID computation. Grouping allows wages and QP to also be aggregated and a single computation used for purposes of the QBID (eligibility and amount). In addition, taxpayers can allocate W2 wages to the appropriate entity that employs the employee under common law. Note: The wages and QP from any trade or business that produces net negative QBI is not taken into account and is not carried over to a later year. The taxpayer has to offset the QBI attributable to each trade or business that produced net positive QBI. Without aggregation, the taxpayer must compute W-2 wages for each trade or business, even if there is more than one within a single corporation or partnership. That means a taxpayer must find a way to allocate a single payroll across different lines.

To be able to aggregate businesses, they must meet several requirements, but the primary one is that the same person or group of persons must either directly or indirectly own 50 percent or more of each trade or business. For purposes of the 50 percent test, a family attribution rule applies that includes a spouse, children, grandchildren and parents of the taxpayer. However, siblings, uncles, and aunts, etc., are not within the family attribution rule. To illustrate the rule, for example, the parents and a child could own a majority interest in three separate businesses and all three of those businesses could be aggregated. But, the bar on siblings, etc., counting as "family" is a harsh rule for agricultural operations in particular. Perhaps the final regulations will modify the definition of "family." Note: A “group of persons” can consist of unrelated persons. It is important that the “group” meet the 50 percent test. It is immaterial that no person in the group meets the 50 percent test individually. Common ownership is not all that is necessary to be able to group separate trade or business activities. The businesses to be grouped must provide goods or services that are the same or are customarily offered together; there must be significant centralized business elements; and the businesses must operate in coordination with or reliance upon one another. Meeting this three-part test should not be problematic for most farming/ranching operations, but there is enough "wiggle room" in those definitions for the IRS to create potential issues. Once a taxpayer chooses to aggregate multiple businesses, the businesses must be aggregated for all subsequent tax years and must be consistently reported. The only exception is if there is a change in the facts and circumstances such that the aggregation no longer qualifies under the rules. So, disaggregation is generally not allowed, unless the facts and circumstances changes such that the aggregation rules no longer apply. Losses. If a taxpayer’s business shows a loss for the tax year, the taxpayer cannot claim a QBID and the loss carries forward to the next tax year where it becomes a separate item of QBI. If the taxpayer has multiple businesses (such as a multiple entity farming operation, for example), the proposed regulations require a loss from one entity (or multiple entities) to be netted against the income from the other entity (or entities). If the taxpayer’s income is over the applicable threshold, the netting works in an interesting way. For example, if a farmer shows positive income on Schedule F and a Schedule C loss, the Schedule C loss will reduce the Schedule F income. The farmer’s QBID will be 20 percent of the resulting Schedule F income limited by the qualified wages, or qualified wages and the QP limitation. Of course, the farmer may be able to aggregate the Schedule F and Schedule C businesses and would want to do so if it would result in a greater QBID. Note: A QBI loss must be taken and allocated against the other QBI income even if the loss entity is not aggregated. However, wages and QP are not aggregated. If the taxpayer had a carryover loss from a pre-2018 tax year, that loss is not taken into account when computing income that qualifies for the QBID. This can be a big issue if a taxpayer had a passive loss in a prior year that is suspended. That's another taxpayer unfriendly aspect of the proposed regulations. Trusts. For trusts and their beneficiaries, the QBID can apply if the $157,500 threshold is not exceeded irrespective of whether the trust pays qualified wages or has QP. But, that threshold appears to apply cumulatively to all trust income, including the trust income that is distributed to trust beneficiaries. In other words, the proposed regulations limit the effectiveness of utilizing trusts by including trust distributions in the trust’s taxable income for the year for purposes of the $157,500 limitation. Prop. Treas. Reg. §1.199A-6(d)(3)(iii). This is another taxpayer unfriendly aspect of the proposed regulations. Based on the Treasury's position, it will likely be more beneficial for parents, for example, for estate planning purposes, to create multiple trusts for their children rather than a single trust that names each of them as beneficiaries. The separate trusts will be separately taxed. The use of trusts can be of particular use when the parents can't utilize the QBID due to the income limitation (in other words, their income exceeds $415,000). The trusts can be structured to qualify for the QBID, even though the parents would not be eligible for the QBID because of their high income. However, the proposed regulations state that,

“Trusts formed or funded with a significant purpose of receiving a deduction under I.R.C. §199A will not be respected for purposes of I.R.C. §199A.” Again, that's a harsh, anti-taxpayer position that the proposed regulations take. Under I.R.C. §643(f) the IRS can treat two or more trusts as a single trust if they are formed by substantially the same grantor and have substantially the same primary beneficiaries, and are formed for the principle purpose of avoiding income taxes. Does the statement in the proposed regulations referenced above mean that the Treasury is ignoring the three-part test of the statute? By itself, that would seem to be the case. However, near the end of the proposed regulations, there is a statement reciting the three-part test of I.R.C. §643(f). Prop. Treas. Reg. §1.643(f)-1). Hopefully, that means that any trust that has a reasonable estate/business planning purpose will be respected for QBID purposes, and that multiple trusts will not be aggregated that satisfy I.R.C. §643(f). Time will tell what the IRS position on this will be. Unfortunately, the proposed regulations do not address how the QBID is to apply (or not apply) to charitable remainder trusts. Miscellaneous Here are a few other observations from the proposed regulations:

 Guaranteed payments in a partnership and reasonable compensation in an S corporation are not qualified wages for QBID purposes.  Inherited property that the heir immediately places in service gets a fair market value as of date of death basis, but the proposed regulations don’t mention whether this resets the property’s depreciation period for QP purposes (as part of the 2.5 percent computation).  For purposes of the QP computation, the 2.5 percent is multiplied by the depreciated basis of the asset on the day it is transferred to an S corporation, for example, but it’s holding period starts on the day it was first used for the business before it is transferred.  A partnership’s I.R.C. §743(b) adjustment does not count for QP purposes. In other words, the adjustment does not add to UBIA. Thus, the inheritance of a fully depreciated building does not result in having any QP against which the 2.5 percent computation can be applied. That's a harsh rule from a taxpayer's standpoint.  I. R.C. §1231 gains are not QBI. But, any portion of an I.R.C. §1231 gain that is taxed as ordinary income will qualify as QBI.  Preferred allocations of partnership income will not qualify as QBI to the extent the allocation is for services. This forecloses a planning opportunity that could have been achieved by modifying a partnership agreement to provide for such allocations.

Conclusion The proposed regulations are now subject to a 45-day comment period with a public hearing to occur in mid-October. The proposed rules do not have the force of law, but they can be relied on as guidance until final regulations are issued. From a practice standpoint, rely on the statutory language when it is more favorable to a client than the position the Treasury has taken in the proposed regulations. Numerous questions remain and will need to be clarified in the final regulations. The Treasury will be hearing from the tax section of the American Bar Association, the American Institute of CPAs, other tax professionals and other interested parties. Hopefully, some of the taxpayer unfavorable positions taken in the proposed regulations can be softened a bit in the final regulations. In addition, it would be nice to get some guidance on how the rules will apply to cooperatives and their patrons.

Also, this post did not exhaust all of the issues addressed in the proposed regulations, just the one that are most likely to apply to farming and ranching businesses. For example, a separate dimension of the proposed regulations deals with “specialized service businesses.” That was not addressed.

Monday, August 27, 2018 The Qualified Business Income Deduction and “W-2 Wages" By Roger A. McEowen

Overview The Tax Cuts and Jobs Act (TCJA) created a new deduction for tax years 2018-2025 of up to 20 percent of domestic qualified business income (QBI) from a pass-through entity (e.g., partnership, S corporation or sole proprietorship). Similarly, the deduction is allowed for specified agricultural or horticultural cooperatives. In earlier posts, beginning back in December of 2017, I started detailing various aspects of the new QBI deduction (QBID). The QBID incorporates a limitation based on wages paid, or on wages plus a capital element. The limitation is phased-in for taxpayers with taxable income above a threshold amount - $157,500 for single filers; $315,000 for all other filing statuses. For those taxpayers above the applicable income threshold, the definition of “wages” is important. Does it include commodity wages? What about wages parents pay to their children that are under age 18? Do those count for purposes of the limitation? The definition of “wages” for purposes of the QBID. That’s the focus of today’s post. The Pertinent Formula For taxpayers with taxable income exceeding $157,500 (single) or $315,000 (joint), the QBID for a business is (in general) the lesser of 20 percent of the taxpayer’s qualified business income amount (QBIA) from the trade or business, or a “W-2 wages/qualified property limit” (W-2/QP limit). The W-2/QP limit is the greater of 50 percent of the W-2 wages of the trade or business; or the sum of 25% of the W-2 wages of the trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property of the trade or business. I.R.C. §199A(b)(2). So, by the way the formula works, having W-2 wages and/or qualified property can enhance the ultimate QBID that the taxpayer can claim. That is, for those taxpayers over the applicable threshold. For these taxpayers, the QBID is further reduced through a “phase-in” range of the formula. Taxpayers with taxable income beneath the applicable threshold are not subject to the formula. I.R.C. §§199A(b)(3)(A) and (e)(2)(A). “W-2 Wages” Under the statute, W-2 wages are wages that the taxpayer’s qualified trade or business paid to its employees during the calendar year that ends in the business’s tax year. I.R.C. §199A(b)(4)(A). This Code section references I.R.C. §6051(a)(3) and I.R.C. §6051(a)(8) for the definition of W-2 wages. It is the I.R.C. §6051(a)(3) definition that is pertinent to our discussion, as I.R.C. §6051(a)(8) concerns elective deferrals and other types of deferred compensation. In particular, I.R.C. §6051(a)(3) specifies that total wages are defined in I.R.C. §3401(a). That definition generally excludes wages paid for agricultural labor, unless it is wages (as defined in I.R.C. §3121(a)) paid for agricultural labor (as that term is defined in I.R.C. §3121(g)). Under the I.R.C. §3121(a) definition of “wages,” agricultural wages paid in-kind are disqualified (I.R.C. §3121(a)(8)(A)), as are cash wages paid to an employee for agricultural labor unless the employee pays at least $150 in cash wages to the employee for the year and the employer’s expenditures for agricultural labor for the year equal or exceed

$2,500. I.R.C. §3121(a)(8)(B)(i)-(ii). Wages paid to children under age 18 by their parents are not specified as an exception in I.R.C. §3401(a). However, under IRC §3401(a)(2), commodity (“in-kind”) wages are not included because they are not “wages” under I.R.C. §3121(a)(8)(A). They are specifically excluded from the definition of “wages.” The bottom line is that wages paid to children under age 18 by their parents count as wages for QBI purposes, but agricultural wages paid in-kind do not. In addition, the wages must be paid for amounts that are properly allocable to producing QBI. Additionally, under I.R.C. §199A(b)(4)(C) the term “W-2 wages” does not include any amount that is not properly included in a return filed with Social Security Administration (SSA) on or before the 60th day after the due date (including extensions) for such return. Thus, wages, whether they are “required” in a technical sense to be reported, must be reported to count as “W-2 wages” for purposes of I.R.C. §199A. Wages paid to children under age 18 in the employ of their parents are subject to withholding, but are often exempt because the amount is less than the standard deduction. Reporting such wages to SSA on a timely filed return will cause them to count as “W-2 wages” for QBID purposes. Conclusion The QBID is a complex provision, for sole proprietors and other business owners that operate in a business form that is something other than a C corporation. That’s especially true for taxpayers with income over the applicable threshold. While ag wages paid in-kind don’t count as “W-2 wages” for purposes of the QBID formula for higher income taxpayers, wages paid to children under age 18 by their parents do count. That can generate a larger QBID for those taxpayers that are subject to the wages/qualified property limitation.

Tuesday, January 22, 2019 QBID Final Regulations on Aggregation and Rents – The Meaning For Farm and Ranch Businesses By Roger A. McEowen Overview Last August, the Treasury issued proposed regulations under I.R.C. §199A that was created by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017. REG-107892-18 (Aug. 8, 2018). The proposed regulations were intended to provide taxpayers guidance on planning for and utilizing the new 20 percent pass- through deduction (known as the QBID) available for businesses other than C corporations for tax years beginning after 2017. It expires for years beginning after 2025. While some aspects of the proposed regulations are favorable to agriculture, other aspects created additional confusion, and some issues were not addressed at all (such as the application to agricultural cooperatives). A public hearing on the final regulations was held in Washington, D.C. on October 16, 2018 and the Treasury released the final QBID regulations on January 18, 2019. The final regulations provide much needed guidance on several key points. Today’s post does not provide an overview of the 199A provision (for that background information you can read my prior post here https://lawprofessors.typepad.com/agriculturallaw/2018/01/the- qualified-business-income-qbi-deduction-what-a-mess.html and here https://lawprofessors.typepad.com/agriculturallaw/2018/03/congress-modifies-the-qualified- business-income-deduction.html. What I am focusing on today is the impact of the final regulations on farm and ranch businesses - that’s the topic of today’s post.

Aggregation Multiple businesses. The proposed regulations did provide a favorable aggregation provision that allows a farming operation with multiple businesses (e.g., row-crop; livestock; etc.) to aggregate the businesses for purposes of the QBID. This was, perhaps, the best feature of the proposed regulations with respect to agricultural businesses because it allows a higher income farming or ranching business to make an election to aggregate their common controlled entities into a single entity for purposes of the QBID. This is particularly the case with entities having paid no wages or that have low or no qualified property. Entities with cash rental income already qualified the income as QBI via common ownership (common ownership is required to aggregate). Once the applicable threshold for 2018 ($157,500 for a single filer; $315,000 for a married filing joint return) is exceeded, the taxpayer must have qualified W-2 wages or qualified property basis to claim the QBID. Aggregation, in this situation, may allow the QBID to be claimed (assuming the aggregated group has enough W-2 wages or qualified property). Proposed regulations. Common ownership is required to allow the aggregation of entities to maximize the QBID for taxpayers that are over the applicable income threshold. Prop. Treas. Reg. §1.199A- 4(b). “Common ownership” requires that each entity has at least 50 percent common ownership. But, the common ownership rule does not require every person involved to have an ownership in every trade or business that is being aggregated, or that you look to the person’s lowest percentage ownership. For example, person A could have a 1 percent ownership interest in entity X and a 99 percent ownership interest in entity Y, and an unrelated person could have the opposite ownership (99 percent in x and 1 person in Y) and the entities would have common ownership of 100 percent (the group of people have 50 percent or more common ownership). But, there was a potential snag with the definition, and it concerned a family attribution rule that could pose issues for farming operations involving family members with multiple generations. The proposed regulations limited family attribution to just the spouse, children, grandchildren and parents. See Prop. Treas. Reg. §1.199A-4(b)(3). In other words, the proposed regulations limited common ownership to lineal ancestors and descendants. Excluded were siblings – which are often involved in farming and ranching businesses. One way to plan around the lack of sibling attribution, for example, was to have one child own 100 percent of one business and another child of the same parent own 100 percent of another business. In that situation, the parent is deemed to have 100 percent ownership of both businesses even though there is no sibling attribution. The two businesses could be aggregated, even though there is no sibling attribution, as long as at least one parent is alive. The proposed regulations were also unclear concerning whether (for taxpayers over the applicable income threshold) it mattered if the entities are on a calendar or fiscal year-end. In order to elect to aggregate entities together, the proposed regulations required all of the entities in a combined group must have the same year-end, and none can be a C corporation. But, rental income paid by a C corporation in a common group could be QBI if the C corporation was part of that combined group. If this reading were correct, that meant that the rental income could qualify as QBI. That interpretation is beneficial to farming and ranching businesses – many are structured with multiples entities, at least one of which is a C corporation. Final regulations. Fortunately, the final regulations provide that siblings are included as related parties via I.R.C. §§267(b) and 707(b). Including siblings in the definition of common ownership for QBID purposes will be helpful upon the death of the senior generation of a farming or ranching operation. In addition, the final regulations retain the 50 percent test and clarify that the test must be satisfied for a majority of the tax year, at the year-end, and that all of the entities of a combined group must have the same year-end. The final regulations also specify that aggregation for 2018 can be made on an amended return. The aggregation election can be made in a later year if it was not made in the first year.

Rental Activities – What’s Business Income? One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI. The proposed regulations confirmed that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s particularly the case if the rental is between “commonly controlled” entities. But, the proposed regulations could also have meant that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID. If that latter situation were correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID. Thus, clarification was needed on the issue of whether the rental of property, regardless of the lease terms will be treated as a trade or business for aggregation purposes as well as in situations when aggregation is not involved. That clarification is critical because cash rental income may be treated differently from crop-share income depending on the particular Code section involved. See, e.g., §1301. Proposed regulations. The proposed regulations also contained an example of a rental of bare land not requiring any cost on the landlord’s part. See Prop. Treas. Reg. §1.199A-1(d)(4), Example 1. This seemed to imply that the rental of bare land to an unrelated third party qualifies as a trade or business. Another example in the proposed regulations also seemed to support this conclusion. Prop. Treas. Reg. §199A- 1(d)(4), Example 2. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. Clarification on this point was also needed. Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations created confusion. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162. But, the Preamble also stated that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, the Preamble raised a question as to whether those separate rental activities can’t be aggregated unless each rental activity is a trade or business. It also raised a question as to whether the Treasury would be making the trade or business determination on an entity-by-entity basis. If so, triple net leases might not generate QBI. But, another part of the proposed regulations extended the definition of trade or business beyond I.R.C. §162 in one circumstance when it referred to “each business to be aggregated” in paragraph (ii). Prop. Treas. Reg. §1.199A-4(b)(i). This would appear to mean that the rental of property would be treated as a trade or business for aggregation purposes. See Prop. Treas. Reg. §199A-1(b)(13). Final regulations. So how did the final regulations deal with the issue of passive lease income? For starters, the bare land rent example in the proposed regulations was eliminated. Unfortunately, no further details were provided on the QBI definition of trade or business. That means that each individual set of facts will be key with the relevant factors including the type of rental property (commercial or residential); the number of properties that are rented; the owner’s (or agent’s) daily involvement; the type and significance of any ancillary services; the terms of the lease (net lease; lease requiring landlord expenses; short-term; long-term; etc.). Certainly, the filing of Form 1099 will help to support the conclusion that a particular activity constitutes a trade or business. But, tenants-in-common that don’t file an entity return create the implication that they are not engaged in a trade or business activity. The final regulations clarify (unfortunately) that rental paid by a C corporation cannot create a deemed trade or business. That’s a tough outcome as applied to many farm and ranch businesses and will require some thoughtful discussions with tax/legal counsel about restructuring rental agreements and entity set- ups. Before the issuance of the final regulations, it was believed that land rent paid by a C corporation

43 could still qualify as a trade or business if the landlord could establish responsibility (regularity and continuity) under the lease. Landlord responsibility for mowing drainage strips (or at least being responsible for ensuring that they are mowed) and keeping drainage maintained (i.e., tile lines), paying taxes and insurance and approving cropping plans, were believed to be enough to qualify the landlord as being engaged in a trade or business. That appears to no longer be the case. Notice 2019-7. Along with the release of the final regulations, the IRS issued Notice 2019-7. The Notice is applicable for tax years ending after December 31, 2017 and can be relied upon until the final Revenue Procedure is published. The Notice provides tentative guidance and a request for comments on the sole subject of when and if a rental activity (termed as a “rental real estate enterprise) will be considered to be an active trade or business. The Notice also provides a safe harbor. While real estate rented or leased under a triple net lease is not eligible under the safe harbor (unless common control allows it), a taxpayer who has an active business of entering into and selling triple net leases may still be considered to be sufficiently active to qualify as a trade or business under existing case law. The Notice defines a triple net lease to include an agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance in addition to rent and utilities, and includes leases that require the tenant to pay common area maintenance expenses, which are when a tenant pays for its allocable portion of the landlord’s taxes, fees, insurance, and maintenance activities which are allocable to the portion of the property rented. The definition seems to leave open the ability to avoid triple net lease status by having the tenant be responsible for some portion of the maintenance, taxes, fees, insurances, and other expenses that would normally be payable by a landlord. However, failure to meet the safe harbor does not fully preclude the lease from generating QBI. Note: For landowners receiving annual “wind lease” income for aerogenerators on their farmland, even though the income is received as part of a common controlled group, the actual income is not paid by any member of the controlled group. It is essentially triple net lease income with no services provided by the farmer (or spouse). This income will not be QBI, given the inability of the landowner to provide “services” under the lease agreement. An individual may rely on the safe harbor, as well as a partnership or S-corporation that owns the applicable interest in the real estate that is leased out (such as farmland). As noted above, the final regulations take the position that the lessor entity must be a pass-through entity (or a sole proprietorship) that owns the real estate directly or through another entity that is disregarded for income tax purposes. Rent that is paid by a C corporation doesn’t count. Each individual taxpayer, estate or trust can elect to treat each separate property as a separate enterprise, or all similar properties as a single enterprise, for purposes of applying the safe harbor rules, except that commercial and residential real estate cannot be considered as part of the same enterprise for testing purposes. In other words, all commercial rents can be netted as one single enterprise, and all residential rentals can be netted as another enterprise. But, real estate that is under a triple net lease, and real estate used as a residence by the taxpayer cannot be part of an aggregated enterprise for testing purposes because they cannot qualify to be included in the safe harbor. The Notice specifies that for each separate enterprise, certain requirements must be satisfied each year for the enterprise’s income to be eligible for the safe harbor:

 Maintenance of separate books and records to reflect the income and expenses for each enterprise.  Aggregate records for properties that are grouped as a single enterprise.  Contemporaneous records (similar to auto logs) of time reports, logs, etc., with respect to services performed and the party performing the services with respect to tax years beginning January 1, 2019. The requirement is inapplicable to 2018 returns or fiscal year filers for years ending before 2020.  For tax years 2018 through 2022, 250 or more hours of “rental services” must be performed to qualify the property for the safe harbor in each calendar year. Rental services include time spent by owners,

employees, agents, and independent contractors of the owners, which can include management and maintenance companies who have personnel who keep and provide contemporaneous records. Rental services also include advertising to rent or lease properties; negotiating and executing leases; verifying tenant information; collecting rent; daily management and repairs; buying materials and supervising employees and independent contractors.

The safe harbor requirements will most likely be easier to satisfy by taxpayers having multiple properties, and cannot be used by a taxpayer that rents their personal residence(s) out for part of the year. While most rental house scenarios, cash rents and crop shares won’t qualify for the safe harbor, they may qualify under common control without regard to any hour requirement, or they can still generate QBI based on the overall facts and circumstances. Conclusion Thursday’s post will continue the discussion of the impact of the final QBI regulations on farming and ranching businesses. In that post, I will look a little further into the trade or business issue, discuss W-2 wages, and examine how the final regulations address the unadjusted basis in assets (UBIA) issue for QBI purposes. In addition, I will comment on numerous miscellaneous provisions, including the treatment of capital gains and the deductions that reduce QBI, just to name a couple. Also, I will take a look at how the final regulations treat commodity transactions, and how they apply to trusts and estates.

Thursday, January 24, 2019 The QBID Final Regulations – The “Rest of the Story” By Roger A. McEowen Overview As noted on Tuesday’s post, the Treasury issued final regulations for the qualified business income deduction (QBID) under I.R.C. §199A on January 18. This provision, of course, provides for a 20 percent deduction on business income received by a sole proprietor or member of a pass-through entity. On Tuesday, I discussed how the final regulations affected rental situations for farmers and ranchers and also how the final rules dealt with aggregation. In today’s post, I look at numerous other issues associated with I.R.C. §199A and the final regulations that are important to farmers and ranchers The rest of the story, so to speak, concerning the QBID final regulations and farmers and ranchers – that’s the topic of today’s post. Losses Proposed regulations. Under the proposed regulations, carryover losses that were incurred before 2018 and that are now allowed in years 2018-2025 will be ignored in calculating qualified business income (QBI) for purposes of the QBID. This is an important issue for taxpayers that have had passive losses that have been suspended under the passive loss rules. While this loss allocation rule is generally favorable, clarification was needed on a couple of points. For instance, could a taxpayer also ignore pre- 2018 suspended losses for purposes of the Excess Business Loss rule under I.R.C. §461(l)? Final regulations. The final regulations, consistent with the regulations issued under former I.R.C. §199, provide that any losses that are disallowed, suspended, or limited under I.R.C. §465 (passive loss rules) §704 and I.R.C. §1365 (or any other similar provision) are to be used on a first-in, first-out basis.

In addition, the final regulations clarify that an NOL deduction (in accordance with I.R.C. §172) is generally not considered to be in connection with a trade or business. Excess business losses (the amount over $500,000 (mfj)) are not allowed for the tax year. However, an Excess Business Loss under I.R.C. §461(l) is treated as an NOL carryover to the next tax year where it reduces QBI in that year. The carry forward becomes part of the taxpayer's NOL carryforward in later years. There is no mention whether this amount gets retested under I.R.C. §461(j)(involving subsidized farming losses). Under prior law, those disallowed losses retained their character in a later tax year. That is no longer the case and it appeared that the NOL generated under I.R.C. §461(l) would not be subject to other loss limitation provisions. Included and Excluded Items QBI includes net amounts of income, gain, deduction, and loss with respect to any qualified trade or business. I.R.C. §199A(c). Business-related items that constitute QBI include ordinary gains and losses from Form 4797; deductions that are attributable to a business that is carried on in an earlier year; the deduction for self-employed health insurance under I.R.C. §162(l); and the deductible portion of self- employment tax under I.R.C. §164(f). The final regulations affirm this. Treas. Reg. §1.199A- 3(b)(1)(vi). The reduction of QBI for self-employed health insurance, for an S corporation shareholder or partner occurs at the entity level. It is removed for an S corporation, for example on Form 1120-S. It should not be deducted twice. If QBI were reduced by the amount of the I.R.C. §162(l) deduction on Form 1040, QBI would (incorrectly) be reduced twice. The final regulations also clarify that the deduction for contributions to qualified retirement plans under I.R.C. §404is considered to be attributable to a trade or business to the extent that the taxpayer’s gross income from the trade or business is accounted for when calculating the allowable deduction, on a proportionate basis. The final regulations do not address how deductions for state income tax imposed on the individual’s business income or unreimbursed partnership expenses are to be treated. The final regulations also don’t mention whether the deduction for interest expense to a partnership interest or an S corporation interest is business related. Guaranteed payments for the use of capital in a partnership are not attributable to the partnership’s business, unless they are properly allocable to the recipient’s qualified trade or business (not likely). Also excluded from QBI are amounts that an S corporation shareholder receives as reasonable compensation or amounts a partner receives as payment for services under I.R.C. §§707(a) or (c). Capital Gain Proposed regulations. The proposed regulations appeared to take the position that gain that is “treated” as capital gain is not QBI. Prop. Treas. Reg. 1.199A-3(b)(2)(ii)(A). This interpretation would exclude I.R.C. §1231 gain (such as is incurred on the sale of breeding livestock) from being QBI-eligible. But, it could also be argued that is an incorrect interpretation of the relevant Code provisions. It also is arguably inconsistent with the purpose of the QBID statute. I.R.C. §1222(3) defines long-term capital gain as the gain from the sale or exchange of a capital asset held for more than one year, if and to the extent the gain is taken into account in computing gross income. I.R.C. §1231(a)(1) treats the I.R.C. §1231 gains as long- term capital gain. I.R.C. §199A(a)(2)(B) neither modifies nor makes any other specification. Also, I.R.C. §1222(11) defines “net capital gain” as the excess of the net long-term capital gain for the year over the net short-term capital loss. None of the other provisions on I.R.C. §1222 mention I.R.C. §1231. Simply because, as the proposed regulations state, gain is “treated as” capital gain does not make it capital gain. Rather, “treated as” should be read in a manner that the tax on I.R.C. §1231 gain is computed in the same manner as capital gain. I.R.C. §1231 reflects gain on the disposition of a business asset. As such, the argument is, I.R.C. §1231 gain should be QBI because the purpose of I.R.C. §199A is to provide a lower tax rate on business income. Losses from the sale of short-term depreciable assets (Part II of Form 4797) should not reduce QBI if I.R.C. §1231 gains (Part 1 of Form 4797) are present. Final regulations. So how did the final regulations deal with this issue? The final regulations remove the specific reference to I.R.C. §1231 and provide that any item of short-term capital gain, short-term capital

46 loss, long-term capital gain, or long-term capital loss, including any item treated as one of these under any Code provision, is not taken into account as a qualified item of income, gain, deduction or loss. That’s comprehensives. It’s basically any item that is reported on Schedule D plus qualified dividends. Qualified dividends are specifically included in the term “capital gain” by reference to I.R.C. §1(h). Commodity trading. Proposed regulations. The proposed regulations provided that “brokering” is limited to trading securities for a commission or a fee. Prop. Treas. Reg. §199A-5(b)(2)(x). Clarification was needed to ensure that brokering of commodities did not constitute a specified service trade or business (SSTB). An SSTB is eligible for the QBID, but under a different set of rules that apply to non-SSTB businesses (such as farms and ranches). For instance, the concern was that under the proposed regulations a person who acquired a commodity (such as wheat or corn for a hog farm), and transported it to the ultimate buyer might improperly be considered to be dealing in commodities. This would have resulted in the income from the activity treated from an SSTB. None of the commodity income would have been eligible for the QBID for a high-income taxpayer. Final regulations. This is also an important issue for private grain elevators. A private grain elevator generates income from the storage and warehousing of grain; it also generates income from the buying and selling of grain. Is the private elevator’s buying and selling of grain “commodity dealing” for purposes of I.R.C. §199A? If it is, then a significant portion of the elevator’s income will not qualify for the QBID. Clarification was needed to distinguish that these various services involved do not constitute an SSTB making the income non-QBI. The final regulations clarify that the brokering of agricultural commodities does not constitute an SSTB and does so by pointing to I.R.C. §954. W-2 Wages The final regulations specify that the IRS may provide for methods of computing taxable wages. Simultaneously with the release of the final regulations, the IRS issued Rev. Proc. 2019-11. The Rev. Proc. notes that it applies only for QBID purposes, and recites the W-2 wages definition from the proposed regulations. Thus, statutory employees that a have a Form W-2 with Box 13 marked are not W- 2 wages for QBID purposes. Also, wages paid in-kind to agricultural labor are not eligible W-2 wages, but wages paid to children under age 18 are. I explained this distinction in an earlier post that you can read here: https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income- deduction-and-w-2-wages.html. The proposed regulations set forth three methods for computing W-2 wages – unmodified box method; modified box 1 method; and the tracking wages method. The Rev. Proc. also provided special rules to use for a short tax year which requires the use of the tracking wages method.

Multiple Trades or Businesses The final regulations follow the approach of the proposed regulations concerning a taxpayer that has multiple trades and businesses. Items of QBI that are properly allocable to more than a single trade or business must be allocated among the several trades or businesses to which they are attributed using a reasonable method based on the facts. That method is to be consistently applied each year. The same concept applies for individual items. Income Tax Basis Proposed regulations. Under I.R.C. §199A, higher income taxpayers compute their QBID in accordance with a wages/qualified property (QP) limitation. The amount of QP that is used in the limitation is tied to the what is known as the “unadjusted basis in assets” (UBIA). However, the proposed regulations raised some questions about UBIA that needed clarified.

For instance, Prop. Treas. Reg. §1.199A-4(b), Example 3, needed modified. When a tax-free contribution of property to a corporation is involved, the transferor’s unadjusted basis should continue to be the UBIA. The placed-in-service date would be the date that the transferor originally placed the property in service. I.R.C. §351should simply be viewed as a continuation of the taxpayer’s holding. The only difference is that the asset is being held via the S corporation. Indeed, the tax attributes of the contributed asset remain unchanged. Likewise, the transferor’s depreciation history with respect to the contributed asset carries into the S corporation. Thus, the unadjusted basis should also carry into the corporation. Final regulations. The final regulations clarify that the UBIA of property received in either an I.R.C. §1031 or 1033 exchange is the UBIA of the relinquished property. In addition, the placed-in-service date of the replacement property is the service date of the relinquished property. Similar concepts apply for transfers that are governed by I.R.C. §§351, 721 and 731. The final regulations also take the position that property contributed to a partnership or S corporation under the non-recognition rules retains the UBIA of the contributor. In addition, an I.R.C. §743(b) adjustment is QP to the extent of an increase in fair market value over original cost. For entities, the UBIA is measured at the entity level, and the property must be held by the entity as of the end of the entity’s tax year. As for a decedent’s estate, the fair market value of property that is received from a decedent pegs the UBIA and the new depreciation period (for purposes of the computation of the limitation) is reset as of the date of the decedent’s death. Trusts The final regulations specify that a non-grantor trust that is established for “a primary purpose” of avoiding income tax under I.R.C. §199A will be considered to be aggregated with trust settlor/grantor for QBID purposes. In addition, distributable net income (DNI) transferred from a non-grantor trust to a beneficiary is treated as having been received by the beneficiary. This could lead to an increase in the creation of non-grantor, irrevocable, complex trusts. The final regulations also did not place any limitation on the use of irrevocable trusts that are considered to be owned by the beneficiary(ies). See I.R.C. §678. However, this does not necessarily mean that there should be a rush to create irrevocable trusts. The IRS, supported by the courts, often view the substance of a transaction as more controlling than form when it believes that the entity was created primarily for tax avoidance purposes. See, e.g., Helvering v. Gregory, 293 U.S. 465 (1935). Miscellaneous Under the final regulations, a veterinarian is engaged in the provision of health care and, therefore, is an SSTB. But, no clarity was given as to the treatment of insurance salesmen – they are often statutory employees. However, the final regulations do contain a three-year lookback period on the reclassification of workers from employee (W-2) status to independent contractor (Form 1099) reporting. Employees do not have QBI, but independent contractors can. Conclusion The final regulations are effective upon being published in the Federal Register. But, in general, a taxpayer can rely on either the final or proposed regulations for tax years that end in 2018. Some parts of the final regulations apply to tax years ending after December 22, 2017, or to tax years ending after August 16, 2018. However, these situations apply to the anti-abuse rules, including the anti-abuse rules that apply to trusts.

Friday, June 21, 2019 Ag Cooperatives and the QBID – Initial Guidance By Roger A. McEowen Overview It has taken the IRS and the Treasury almost 18 months to issue proposed regulations on how the new Qualified Business Income Deduction (QBID) works with respect to qualified agricultural cooperatives and their patrons. For background information on the QBID see https://lawprofessors.typepad.com/agriculturallaw/2018/01/the-qualified-business-income-qbi- deduction-what-a-mess.html Of course, the Congress didn’t help anything when the Tax Cuts and Jobs Act was passed by including a special deal for cooperatives that private grain elevators couldn’t avail themselves of. That got “fixed” in late March of 2018, but by that time the air and water in D.C. had become so polluted over the cooperative issue that I was told personally by Senator Grassley not to anticipate any proposed regulations until the middle of 2019. For commentary on the “fix” see https://lawprofessors.typepad.com/agriculturallaw/2018/03/congress-modifies-the-qualified- business-income-deduction.html The Senator was spot- on with that prediction. Now that we have the proposed regulations, this will be a topic that will be addressed at the 2019 Summer National Farm Income Tax and Estate/Business Planning Seminar in Steamboat Springs, Colorado on August 13-14. That event is sponsored by Washburn University School of Law, the Department of Ag Econ at Kansas St. University and WealthCounsel. You can attend either in person or online. Registration information is available here: http://washburnlaw.edu/employers/cle/farmandranchtaxregister.html A brief summary of the cooperative QBID regulations – that’s the topic of today’s post. No Deduction for a Cooperative Under I.R.C. §199A(a), a taxpayer is eligible for up to a 20 percent QBI deduction (QBID) attributable to qualified business income (QBI) derived from a domestic business that is other than a C corporation. Trusts and estates are eligible for the deduction. But, the QBID does not apply to wage income or to C corporate income. A cooperative is deemed to be a C corporation for federal income tax purposes and, thus, cannot claim a QBID. But, a cooperative determines its taxable income after the deduction for patronage dividend distributions and the like. I authored a BNA Tax Management Portfolio several years ago on cooperative taxation and noted there that such distributions are not taxed at the cooperative level. Instead, the distributions are taxed at the patron level. All cooperatives can deduct patronage distributions; exempt cooperatives can also deduct non-patronage distributions. I.R.C. §1382(c). While a C corporation cannot utilize the QBID, I.R.C. §199A has a special rule for patrons that receive patronage dividends – they aren’t treated as an exclusion to the patron’s QBI. I.R.C. §199A(c)(3)(B)(ii). In addition, the Treasury has said that for purposes of the trade or business test of I.R.C. §162 (a pre- requisite for QBI), the income is tested at the trade or business level where the income is generated. T.D. 9847, Feb. 12, 2019. This all means that the QBID, if any, is at the patron level and not the cooperative level. Special Rule for Patrons As noted, I.R.C. §199A has special rules for patrons of ag cooperatives. These rules stem from the fact that farmers often do business with agricultural (or horticultural) cooperative. A farmer patron could have QBI that is not tied to patronage with a cooperative and QBI that is tied to patronage with a cooperative. What are “patronage dividends”? Patronage dividends include money, property, qualified written notices of allocations, qualified per-unit retain certificates for which a cooperative receives a deduction under I.R.C. §1382(b), nonpatronage distributions paid in money, property, qualified written notices of

49 allocation, as well as money or property paid in redemption of a nonqualified written notice of allocation for which an exempt cooperative receives a deduction under I.R.C. §1382(c)(2). But, dividends on capital stock are not included in QBI. Prop. Treas. Reg. §1.199A-7(c)(1). Under Prop. Treas. Reg. §1.199A-7(c), patronage dividends or similar payments may be included in the patron’s QBI to the extent that these payments: (i) are related to the patron’s trade or business; (ii) are qualified items of income, gain, deduction, or loss at the cooperative’s trade or business level; and (iii) are not income from a specified service trade or business (SSTB) (as defined in I.R.C. §199A(d)(2)) at the cooperative level. But, they are only included in the patron’s income if the cooperative provides the required information to the patron concerning the payments. Prop. Treas. Reg. §199A-7(c)(2). The patron’s QBID. The amount of a patron’s deduction that can be passed through to the patron is limited to the portion of the patron’s deduction that is allowed with respect to qualified production activities income to which the qualified payments (patronage dividends and per unit retains) made to the patron are attributable. I.R.C. §199A(g)(2)(E). In other words, the distribution must be of tax items that are allocable to the cooperative’s trade or business on behalf of or with a patron. The cooperative makes this determination in accordance with Treas. Reg. §1.199A-3(b). This is, essentially, the domestic production activities deduction computation of former I.R.C. §199, except that account is taken for non- patronage income not being part of the computation. Note. There is a four-step process for computing the patron’s QBID: 1) separate patronage and non- patronage gross receipts (and associated deductions); 2) limit the patronage gross receipts to those that are domestic production gross receipts (likely no reduction here); 3) determine qualified production activities income from the domestic, patronage-sourced gross receipts; 4) apply a formula reduction (explained below). Prop. Treas. Reg. §1.199A-8(b). As noted, the farmer-patron must reduce the “patron’s QBID” by a formula that is the lesser of 9 percent of QBI that relates to qualified payments from the cooperative, or 50 percent of the patron’s W-2 wages paid that are allocable to the qualified payments from the cooperative. I.R.C. §199A(b)(7)(A)-(B). In Notice 2019-27, 2019-16 IRB, the IRS set forth various methods for calculating W-2 wages for purposes of computing the patron’s QBID. See also Prop. Treas. Reg. §1.199A-11. Because the test is the “lesser of,” a patron that doesn’t pay qualified W-2 wages has no reduction. Remember, however, under I.R.C. §199A(b)(4) and Prop. Treas. Reg. §1.199A-11(b)(1), wages paid in-kind to agricultural labor are not “qualified wages” but wages paid to children under age 18 by their parents are. For background information on that point, see https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income- deduction-and-w-2-wages.html Note. I.R.C. §199A(b)(7) requires the formula reduction even if the cooperative doesn’t pass through any of the I.R.C. §199A(g) deduction (the deduction for a patron) to the patron for a particular tax year. If the patron has more than a single business, QBI must be allocated among those businesses. Treas. Reg. §1.199A-3(b)(5). Uncertainty remains, however, as to how the formula reduction functions in the context of an aggregation election. For example, if an aggregation election is made to aggregate rental income with income from the farming operation, must an allocation be made of a portion of the rental income as part of the formula reduction? The formula reduction applies to the portion of a patron’s QBI that relates to qualified payments from a cooperative. If the patron has negative QBI that is associated with business done with the cooperative, the 9 percent amount will always be lower than the W-2 wage amount. Based on the draft form 8995-A, the QBID is to be increased by 9 percent of the AGI amount. An optional safe harbor allocation method exists for patrons under the applicable threshold of I.R.C. §199A(e)(2) ($160,700 single/$321,400 MFJ for 2019) to determine the reduction. Under the safe harbor, a patron must allocate the aggregate business expenses and W-2 wages ratably between qualified payments and other gross receipts to determine QBI. Prop. Treas. Reg. §1.199A-7(f)(2)(ii). Thus, the

50 amount of deductions apportioned to determine QBI allocable to qualified payments must be equal to the proportion of the total deductions that the amount of qualified payments bears to total gross receipts used to determine QBI. The same proportion applies to determine the amount of W-2 wages allocable to the portion of the trade or business that received qualified payments. Note. The proposed regulations attempting to illustrate the calculation only mention gross receipts from grain sales. There is no mention of gross receipts from farm equipment, for example. Based on the language of Prop. Treas. Reg. §1.199A-7(f)(2)(ii), gross receipts from the sale of equipment and machinery should be included in the calculation and the farmer would have to allocate gross receipts from equipment sales between patronage and non-patronage income. Indeed, in prior years, depreciation may have been allocated between patronage and non-patronage income. Likewise, the example doesn't address how government payments received upon sale of grain are to be allocated. The example contained in the Proposed Regulations not only utilizes an apparently unstated “reasonable method of allocation,” but uses an allocation of W-2 wage expense that doesn’t match the total expense allocation. That will have to be cleaned up in the final regulations. The example, as written, does not meet the requirement of the regulations to “clearly reflect income” without an explanation of how the cost allocation has been accomplished. A taxpayer using the approach of the example would certainly fail the requirement of the regulations upon audit. This all means that the patron must know the qualified payments from the cooperative that were allocable to the patron that were used in computing the deduction for the patron at the cooperative level that could be passed through to the patron. This information is contained on Form 1099-PATR. A higher income patron that receives patronage dividends (or similar payments) from a cooperative and is conducting a trade or business might be subject to the W-2 wages and “unadjusted basis immediately after acquisition” (UBIA) limitation. See https://lawprofessors.typepad.com/agriculturallaw/2018/08/qualified-business- income-deduction-proposed-regulations.html for a discussion of the limitation. In that instance, the patron is to calculate the W-2 wage and UBIA limitations without regard to the cooperative’s W-2 or UBIA amounts. Prop. Treas. Reg. §1.199A-7(e)(2). That means that the cooperative does not allocate its W-2 wages or UBIA to patrons. Id. Instead, a patron allocates (by election) W-2 wages and UBIA between patronage and non-patronage income using any reasonable method based on all the facts and circumstances that clearly reflects the income and expense of each trade or business. Prop. Treas. Reg. §1.199A-7(f)(2)(i). An example of an allocation might be by the number of bushels of grain that the patron sells during the year to various buyers – cooperatives and non-cooperatives. But, once an election is made with respect to an allocation approach, it applies to all subsequent years. The patron’s QBID that is passed through from the cooperative (which is not limited by W-2 wages at the patron level) is limited to the patron’s taxable income taking into account the non-patron QBID which is limited to 20 percent of taxable income not counting net capital gains. Any unused patron-QBID is simply lost – there is not carryover or carryback provision that applies. Identification by the cooperative. A cooperative must identify the amount of a patron’s deduction that it is passing through to a patron in a notice that is mailed to the patron via Form 1099-PATR during the “applicable payment period” – no later than the 15th day of the ninth month following the close of the cooperative’s tax year. I.R.C. §199A(g)(2)(A); Prop. Treas. Reg. §1.199A-8(d)(3); I.R.C. §1382(d). A patron uses the information that the cooperative reports to determine the patron’s QBID. If the information isn’t received on or before the Form 1099-PATR due date, no distributions from the cooperative will count towards the patron’s QBI if the lack of reporting occurs after June 19, 2019. Prop. Treas. Reg. §1.199A-7(c)(3); Prop. Treas. Reg. §1.199A-7(d)(3). Note. The Preamble to the proposed regulations states that these rules apply to both exempt and nonexempt cooperatives as well as patronage and nonpatronage distributions.

Is the Patron’s Business an SSTB? The proposed regulations indicate that a patron must determine whether the trades or businesses it directly conducts are specified service trades or businesses (SSTBs). Prop. Treas. Reg. §1.199A-7(d)(2). Why? Because the cooperative must report to the patron the amount of tax items from an SSTB that the cooperative directly conducts (based on the application of the gross receipts de minimis rule of Tress. Reg. §1.199A-5(c)(1)) that is used to determine if a trade or business is an SSTB. The patron is to then determine if the distribution from the cooperative can be included in the patron’s QBI (based on the patron’s taxable income and the phase-in range and threshold that applies to an SSTB). The cooperative must report to the patron the amount of SSTB income, gain, deduction, and loss in distributions that is qualified with respect to any SSTB directly conducted by the cooperative on an attachment to or on the Form 1099-PATR (or any successor form) that the cooperative issues to the patron, unless otherwise provided by the instructions to the Form. Note. Again, the Preamble to the proposed regulations states that these rules apply to both exempt and nonexempt cooperatives as well as to patronage and non-patronage distributions. Conclusion Waiting well over a year for draft proposed regulations on the cooperative QBID issue has created many hassles for taxpayers, preparers and tax software companies for the 2018 tax season (which is still ongoing in many respects). The proposed regulations can be relied upon until final regulations are published. Written comments on the proposed regulations are due within 60 days of publication of the proposed regulations in the Federal Register – approximately August 17, 2019. Hard copy submissions of comments can be sent to: CC:PA:LPD:PR (REG-118425-18), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C., 20044.

SESSION TWO – 9:50 a.m.-12:00 p.m.

SELECTED TOPICS IN AG TAXATION

PART ONE – PROPOSED/NEW LEGISLATION; IRS DEVELOPMENTS/REGULATIONS

II. Technical Corrections; Extender legislation and Provisions

A. On January 2, 2019, the Committee on Ways and Means of the U.S. House of Representatives released a draft technical corrections bill that seeks to correct “technical and clerical” issues in the Tax Cuts and Jobs Act of 2017. However, the newly constituted Ways and Means Committee with a Democratic majority is reported to be unlikely to take up the draft according to a staffer who made the comment at a conference in Washington, D.C. on January 29.

B. As of today, legislation to extend “extenders,” i.e. tax provisions with termination dates that are typically extended, has not been enacted.

C. Many of these extender provisions would have been extended through the end of 2018 by a Retirement, Savings, and Other Tax Relief Act of 2018 and the Taxpayer First Act of 2018 (H.R. 88). However, on Dec. 10, 2018, that bill was revised so as to not include those extensions.

D. On January 15, Sen. Charles Grassley (R-IA), Chairman of the Senate Finance Committee stated that his goal is to guide extenders legislation to final enactment. However, he acknowledged that he does not have a specific plan and that no hearings on the subject have been scheduled.

E. On January 19, the Joint Committee on Taxation (JCT) released its annual report on the temporary individual, business, and energy tax extender provisions.

1. Expired individual provisions:

a. Above-the-line deduction for certain higher-education expenses, including qualified tuition and related expenses, under I.R.C. §222.

b. The treatment of mortgage insurance premiums as qualified residence interest under I.R.C. §163(h)(3)(E).

c. The exclusion from income of qualified canceled mortgage debt income associated with a primary residence under I.R.C. §108(a)(1)(E).

2. Expired business provisions:

a. Indian employment tax credit under I.R.C. §45A(f).

b. Accelerated depreciation for business property on Indian reservations under I.R.C. §168(j)(9).

c. American Samoa economic development credit (P.L. 109-432, Sec. 119).

d. Railroad track maintenance credit under I.R.C. §45G(f).

e. 7-year recovery for motorsport racing facilities under I.R.C. §168(i)(15).

f. Mine rescue team training credit under I.R.C. §45N(e).

g. Election to expense advanced mine safety equipment under I.R.C. §179E(g).

h. Special expensing rules for film, television, and live theatrical production under I.R.C.§181.

i. Empowerment zone tax incentives under I.R.C. § 1391(d)(1)(A).

j. 3-year depreciation for race horses two years or younger under I.R.C. §168(e)(3)(A)(i).

3. The expired energy provisions are:

a. The beginning-of-construction date for nonwind facilities to claim the production tax credit (PTC) or the investment tax credit (ITC) in lieu of the PTC under I.R.C. §45(d) and §48(a)(5).

b. The special rule to implement electric transmission restructuring under I.R.C. §451(k).

c. The credit for construction of energy efficient new homes under I.R.C. §45L.

d. The energy efficient commercial building deduction under I.R.C. §179D.

e. Nonbusiness energy property credit under I.R.C. §25C.

f. Alternative fuel vehicle refueling property credit under I.R.C. §30C(g).

g. Incentives for alternative fuel and alternative fuel mixtures under I.R.C. §6426(d)(5) and §6427(E)(6)(c).

h. Incentives for biodiesel and renewable diesel under I.R.C. § 40A(a); I.R.C. §6426(e)(3) and I.R.C. §6427(e)(6)(B).

i. Second generation (cellulosic) biofuel producer credit under I.R.C. §40(b)(6)(J).

j. Credit for production of Indian coal under I.R.C. §45(e)(10)(A).

k. Special depreciation allowance for second generation (cellulosic) biofuel plant property under I.R.C. §168(l).

l. Credit for qualified fuel cell vehicles under I.R.C. §30B.

m. Credit for 2-wheeled plug-in electric vehicles under I.R.C. §30D(g)(3)(E)(ii).

n. The relevant 2018 tax forms/instructions reflect the fact that the above extenders do not apply for 2018 tax years.

F. Proposed tax extender and disaster legislation.

1. S.617, “Tax Extender and Disaster Relief Act of 2019,” was placed on the calendar on March 4, 2019.

2. H.R. 3301, “Taxpayer Certainty and Disaster Relief Act of 2019,” was introduced June 18, 2019.

3. H.R. 1994, “Setting Every Community Up for Retirement Enhancement Act of 2019,” passed the House on May 23. This bill modifies the requirements for employer- provided retirement plans, individual retirement accounts (IRAs), and other tax- favored savings accounts.

a. With respect to employer-provided retirement plans, the bill modifies requirements regarding:

1) multiple employer plans; 2) automatic enrollment and nonelective contributions; 3) tax credits for small employers that establish certain plans; 4) loans; 5) lifetime income options; 6) the treatment of custodial accounts upon termination of section 403(b) plans; 7) retirement income accounts for church-controlled organizations; 8) the eligibility rules for certain long-term, part-time employees; 9) required minimum distributions; 10) nondiscrimination rules; 11) minimum funding standards for community newspaper plans; and 12) Pension Benefit Guaranty Corporation premiums for CSEC plans (multiple employer plans maintained by certain charities or cooperatives).

b. The bill also includes other provisions that:

1) treat taxable non-tuition fellowship and stipend payments as compensation for the purpose of an IRA, 2) repeal the maximum age for traditional IRA contributions, 3) treat difficulty of care payments as compensation for determining contribution limits for retirement accounts, 4) allow penalty-free withdrawals from retirement plans if a child is born or adopted,

5) expand the purposes for which qualified tuition programs (commonly known as 529 plans) may be used, 6) reinstate and increase the tax exclusion for certain benefits provided to volunteer firefighters and emergency medical responders, 7) increase penalties for failing to file tax returns, and 8) require the IRS to share tax information with U.S. Customs Border Protection to administer the heavy vehicle use tax. G. H.R. 3151, “Taxpayer First Act” signed into law on July 1, 2019. The Act effects numerous changes to how the IRS deals with taxpayers. Some have significant effects. Some provisions of note include:

1. Change the seizure requirements with respect to structuring transactions to avoid the $10,000 financial reporting requirement;

2. Clarification of equity relief from joint liability;

3. Modification of procedures for issuance of third-party summons;

4. Changes to the private debt collection;

5. Modernization of the National Taxpayer Advocate;

6. Changes to dealing with misdirected tax refunds;

7. Better address and deal with identity theft, create and internet platform for Form 1099 filings;

8. Expand the use of electronic filing of returns;

9. Mandatory e-filing by exempt organizations;

10. Increase in the penalty for failure to file from $205 to $330;

11. Waiver of some fees by low-income taxpayers;

12. Set new electronic filing requirements for Forms 1099 returns professionally prepared.

III. Miscellaneous Developments

A. IRS Announcement 2019-7, Jan. 28, 2019

1. IRS projects that first refunds will be issued in the first week of February and many refunds to be paid by mid-to-late February like previous years.

2. The IRS expects to issue more than nine out of 10 refunds in less than 21 days. However, it’s possible a tax return may require additional review and take longer.

a. The IRS’s “Where's My Refund” has the most up to date information available about refunds.

b. The tool is updated only once a day, so taxpayers don’t need to check more often.

3. The IRS also notes that refunds, by law, cannot be issued before Feb. 15 for tax returns that claim the Earned Income Tax Credit (EITC) or the Additional Child Tax Credit (ACTC).

a. This applies to the entire refund—even the portion not associated with the EITC and ACTC.

b. While the IRS will process the EITC and ACTC returns when received, these refunds cannot be issued before Feb. 15.

c. Similar to last year, the IRS expects the earliest EITC/ACTC related refunds to actually be available in taxpayer bank accounts or on debit cards starting on Feb. 27, 2019, if they chose direct deposit and there are no other issues with the tax return.

d. “Where’s My Refund?” will be updated with projected deposit dates for most early EITC and ACTC refund filers on Feb. 17, so those filers will not see a refund date on “Where's My Refund?” or through their software packages until then.

e. The IRS, tax preparers and tax software will not have additional information on refund dates, so these filers should not contact or call about refunds before the end of February.

B. EITC Awareness Day – IRS Notice 2019-6.

1. The IRS reminds workers about the earned income tax credit (EITC) and how to correctly claim the credit if they qualify.

2. Eligible families with three or more qualifying children could receive a maximum credit of up to $6,431, while those without children could get up to $519.

3. The IRS recommends that all workers who earned around $54,000 or less learn about the eligibility requirements for the EITC and use the EITC Assistant (here) to determine if they qualify.

C. In Rev. Proc.2019-3 and Rev. Proc. 2019-7, the IRS has updated two Revenue Procedures that list certain issues with respect to which the Associate Chief Counsel will not issue letter rulings or determination letters.

1. Domestic "no rule" area additions:

a. Whether an amount is not included in a taxpayer’s gross income under I.R.C. §61 because the taxpayer receives the amount subject to an unconditional obligation to repay the amount.

b. Whether a taxpayer is engaged in a trade or business under I.R.C. §162.

c. In determining whether a loss for worthless securities is subject to I.R.C. §165(g)(3).

d. Whether two or more trusts will be treated as one trust under I.R.C. §643(f). for purposes of subchapter J of chapter 1.

e. Requests for a ruling that the creditor is not required to report under I.R.C. §6050P a discharge that include as grounds for the request a dispute regarding the underlying liability.

2. International "no rule" areas.

a. In Rev Proc 2019-7, IRS updated the list of areas under the jurisdiction of the Associate Chief Counsel (International) on which it will not issue letter rulings or determination letters.

b. The only change was that former Sec. 4.01(01), relating to former I.R.C. § 367(a), was removed as obsolete.

D. IRS revises form 8862 (information for claiming credits after disallowance).

1. The principal differences in the updated form involve the credit for other dependents, which was enacted as part of the TCJA.

2. The Code provides that, with respect to the earned income credit (EIC), the child tax credit (CTC), additional child tax credit (ACTC), credit for other dependents (ODC), and the American opportunity tax credit (AOTC), if a taxpayer is denied the credit as a result of the deficiency procedures (i.e., other than by reason of a math or clerical error), no credit is allowed for any later tax year unless the taxpayer provides the information via form 8862 that the IRS requires to demonstrate eligibility for the credit. See I.R.C. §§32(k)(2); 24(g)(2); 25A(b)(4)(B).

3. From 2018 to 2025, the TCJA provides a $500 nonrefundable credit for each dependent (as defined in I.R.C. §152) of the taxpayer other than a qualifying child, who is a U.S. citizen, national or resident. I.R.C. §24(h)(4)(A). This credit can also be claimed for a qualifying child for whom the child tax credit under I.R.C. §24(a) is not allowed because the taxpayer didn't include a social security number. I.R.C. §24(h)(4).

4. Revised title.

a. In prior years, the title to the form included the words "refundable credits."

b. The current title omits the word "refundable" to reflect the fact that the ODC is not a refundable credit.

5. New Line 13 requires taxpayers to indicate the names of persons for whom they are claiming the ODC.

6. New Line 15 asks, for each person claimed as a qualifying child or other dependent, is that person the taxpayer's dependent?

7. The previous version of the form asked several questions (Lines 15-18) with respect to taxpayers who had certain child dependents who used an Individual Taxpayer Identification Number (ITIN).

a. Children identified by an ITIN or an adoption taxpayer identification number (ATIN) are no longer qualifying children for the CTC or ACTC.

b. Starting with tax year 2018, child must have been issued a social security number before the due date of his parents' return in order for the parents to claim the CTC for the ACTC for the child. As a result, the questions that had previously been on Lines 15-18 have been dropped from the current form.

8. While the previous instructions stated that taxpayers cannot claim the CTC/ACTC for a child who is not a citizen or national or resident of United States, the new form actually has a question (Line 17) that asks whether a child or other dependent meets those qualifications.

9. AOTC question about Form 1098-T.

a. The previous form asked, "Did the student receive a Form 1098-T from the institution for the year entered on line 1 or the year immediately preceding that year?"

b. That question has been dropped from the current version of the form.

E. An employer can truncate the Social Security number of an employee on Form W-2. and elect to report the number as XXX-XX-1234 or ***-**-1234 instead of providing the full number. The provision is not mandatory. Full numbers are required on copies of the Forms W-2 that are filed with the SSA. The provision is effective after December 31, 2020. 84 Fed. Reg. 31717 (Jul. 3, 2019).

F. 2020 HSA limits: Contribution limit - $3,550 (self); $7,100 (family). Annual deductible on HDHP not less than $1,400 (self); $2,800(family); Out-of-pocket expenses not over $6,900 (self); $13,800 (family). Rev. Proc. 2019-25.

G. Treasury issues final regulations increasing the amount of both the enrollment and renewal user fee from $30 to $67 and removing the initial enrollment user fee. The regulations also increase the amount of the renewal user fee for enrolled retirement plan agents from $30 to $67. 84 Fed. Reg. 20801 (May 13, 2019). Eff. Jun. 12, 2019.

H. To the extent a corporation makes a cash distribution in redemption of stock of a C corp. that used to be an S corp. during the PTTP that is subject to Sec. 301 by reason of Section 302(d), the AAA should drop to the extent of the proceeds of the redemption. Rev. Rul. 2019-13.

IV. New for 2019

A. Medical expenses harder to deduct.

1. For 2018, itemizers could deduct medical expenses to the extent they exceeded 7.5% of the taxpayer’s adjusted gross income (AGI).

2. For 2019, the "floor" beneath medical expense deductions increases to 10%. I.R.C. §213(f).

B. Big shift in the alimony rules.

1. For payments required under divorce or separation instruments that are executed after Dec. 31, 2018, the deduction for alimony payments is eliminated, and recipients of affected alimony payments will no longer have to include them in taxable income.

2. The rules for alimony payments also apply to payments that are required under divorce or separation instruments that are modified after Dec. 31, 2018, if the modification specifically states that the new-for-2019 treatment of alimony payments (not deductible by the payer and not taxable income for the recipient) applies. I.R.C. §§215; 71.

C. ACA’s individual shared responsibility payment is history. Obamacare generally provides that individuals must have minimum essential coverage (MEC) for health care, qualify for an exemption from the MEC requirement, or make an individual shared responsibility payment (i.e., pay a penalty) when they file their federal income tax return.

1. The TCJA reduced the individual shared responsibility payment to zero for months beginning after Dec. 31, 2018. I.R.C. §5000A(c)).

2. The I.R.C. §4980H “employer mandate” (also known as an employer shared responsibility payment, or ESRP) remains on the books. The employer mandate general provides that an employer that employed an average of at least 50 full-time employees, including full-time equivalent employees, on business days during the preceding calendar year is required to pay an assessable payment if: (i) it doesn't offer health coverage to its full-time employees; and (ii) at least one full-time employee purchases coverage through the Marketplace and receives an I.R.C. §36B premium tax credit.

D. Liberalized rules for hardship distributions from 401(k) plans. 401(k) plans may provide that an employee can receive a distribution of elective contributions from the plan on account of hardship (generally, because of an immediate and heavy financial need of the employee; and in an amount necessary to meet the financial need).

1. Under Treas. Reg. §1.401(k)-1(d)(3)(iv)(E), an employee who receives a hardship distribution cannot make elective contributions or employee contributions to the plan and to all other plans maintained by the employer, for at least six months after receipt of the hardship distribution.

2. IRS is to modify Treas. Reg. §1.401(k)-1(d)(3)(iv)(E), by Feb. 9, 2019, to delete the 6-month prohibition on contributions and to make “any other modifications necessary to carry out the purposes of” I.R.C. §401(k)(2)(B)(i)(IV). The revised regs are to apply to plan years beginning after Dec. 31, 2018.

3. Proposed regulations have been issued.

E. Debt-equity documentation regulations will apply to 2019 issuances.

F. Accelerated phase out of tax credit for wind facilities.

1. Taxpayers can elect to have qualified property of certain qualified facilities treated as energy property eligible for a 30% investment credit under I.R.C. §48.

2. The 2016 Appropriations Act phased out the elected I.R.C.§48(a) credit for qualified wind facilities as follows: for a facility, the construction of which began after Dec. 31, 2016 and before Jan. 1, 2018, the credit was reduced by 20%; for a facility, the construction of which began after Dec. 31, 2017 and before Jan. 1, 2019, the credit was reduced by 40%; and for a facility, the construction of which begins after Dec. 31, 2018 and before Jan. 1, 2020, the credit is reduced by 60%. I.R.C. §48(a)(5)(E).

G. Establishing the beginning of construction for credit-eligible energy property.

1. Under I.R.C. §48(a), for purposes of the I.R.C. § 46 investment credit, the energy credit for any tax year is generally the energy percentage of the basis of each energy property placed in service during the tax year.

2. In order to qualify for the credit, construction of the energy property must begin before Jan. 1, 2022. I.R.C. §48(a)(2)(A)(i)(II)).

3. IRS Notice 2018-59, 2018-28 I.R.B. provides guidance to determine when construction has begun on energy property that is eligible for the I.R.C. §48 credit.

H. Many tax-exempt organizations freed from donor disclosure requirement.

1. I.R.C. §6033(a) requires certain tax-exempt organizations to file annual information returns that include information required by forms or regulations such as Form 990; 990-EZ;990-PF and 990-BL.

2. I.R.C.§501(c)(3) organizations that are subject to I.R.C.§6033(a) must furnish information annually setting forth certain items including, "the total of the contributions and gifts received by it during the year, and the names and addresses of all substantial contributors."

3. The implementing regs under I.R.C. §6033(a) generally require all types of tax-exempt organizations to report the names and addresses of all persons who contribute $5,000 or more in a year. In addition, social clubs, fraternal beneficiary societies and domestic fraternal societies must report the name of each person who contributed more than $1,000 during the tax year to be used exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals.

4. I.R.C. §6033(a)(3)(B) provides a discretionary exception from the annual filing requirement under which IRS may relieve any organization (other than a supporting organization described in I.R.C. §509(a)(3) otherwise required to file an information return from filing such a return if IRS determines that the filing is not necessary to the efficient administration of the internal revenue laws.

5. For information returns for tax years ending on or after Dec. 31, 2018, tax-exempt organizations required to file Form 990 or Form 990-EZ, other than those described in I.R.C. §501(c)(3), will no longer be required to provide names and addresses of contributors on their Forms 990 or Forms 990-EZ and thus will not be required to complete these portions of their Schedules B (or complete the similar portions of Part IV of the Form 990-BL).

6. Similarly, organizations described in I.R.C. §§501(c)(7); 501(c)(8) or 501(c)(10) will no longer be required to provide on Forms 990 or Forms 990-EZ the names and addresses of persons who

contributed more than $1,000 during the tax year to be used for exclusively charitable purposes. Rev Proc 2018-38, 2018-31 IRB.

7. The above changes don’t affect:

a. The information required to be reported on Forms 990, 990-EZ, or 990-PF by organizations described in I.R.C. §501(c)(3).

b. The reporting of contribution information, other than the names and addresses of contributors, required to be reported on Schedule B of Forms 990 and 990-EZ and Part IV of the Form 990-BL.

c. The disclosure requirements under I.R.C. §6104(b) or I.R.C. §6104(d) of any information reported on the Schedule B of Forms 990 and 990-EZ and Part IV of the Form 990-BL. As a result, the Revenue Procedure will have no effect on the reporting of Schedule B information that is currently open to public inspection.

d. Organizations relieved of the obligation to report contributors’ names and addresses must continue to keep this information in their books and records in order to permit IRS to efficiently administer the internal revenue laws through examinations of specific taxpayers.

PART TWO – IMPACT OF THE TAX CUTS AND JOBS ACT (TCJA) ON AG CLIENTS

LOSS LIMITATION FOR NON-CORPORATE TAXPAYERS1

Excess Business Loss Rule For tax years beginning after December 31, 2017 and before January 1, 2026, “excess business losses” of a taxpayer other than a C corporation are not allowed for the tax year. An excess business loss is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $500,000 (indexed for inflation) for married taxpayers filing jointly (MFJ) and $250,000 for other taxpayers. These threshold amounts are indexed for inflation.

Note. The TCJA eliminated a provision limiting the deductibility of farm losses in excess of $300,000 (generally) and replaced it with the provision limiting all business losses (farm and nonfarm) to $250,000 ($500,000 for MFJ taxpayers).

In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation for the tax year of the partner or S corporation shareholder.

1 TCJA Sec. 11012, modifying IRC §461.

Note. For purposes of the excess business loss rule, the aggregate amount of business income from multiple business is aggregated and up to $500,000 can be used to offset other income. If the net amount of loss exceeds $500,000, the excess is carried forward as an NOL. In addition, IRC §1231 gains are business income and, as such, will offset business losses.

Net Operating Losses The TCJA made changes affecting how farmers can treat net operating losses (NOLs). For tax years beginning after 2017 and before 2026, a noncorporate farm taxpayer is limited to carrying back NOLs of up to $500,000 for MFJ taxpayers and $250,000 for all other taxpayers.2 NOLs exceeding the threshold must be carried forward to the following year.3 For tax years beginning after December 31, 2017, NOLs can be carried forward indefinitely (as opposed to being limited to a 20-year carryforward under prior law) but they can only offset the lesser of the aggregate NOL carryovers to the tax year, plus the NOL carrybacks to the tax year, or 80% of taxable income computed without regard to the NOL deduction (the former rule allowed a 100% offset).4 In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for nonfarmers). This provision has an immediate effect on any farm corporation that has a fiscal year ending in 2018 insomuch as the corporation will not be allowed to carry back an NOL for five years. Instead, the NOL can only be carried back two years. All other corporate taxpayers can only carry an NOL forward.5

Observation. Fiscal year C corporations that are anticipating a large NOL for a fiscal year ending in 2018 may want to consider switching to a calendar year. Such a switch may allow the corporation to carry the NOL for the year ended December 31, 2017, back five years (farm) or two years (nonfarm). A change to a calendar year requires IRS permission and a valid business reason.

Note. Pre-2018 NOL carryovers are grandfathered such that they can offset 100% of taxable income.

At the time this chapter was published, it was uncertain whether the definition of “taxable income” for purposes of the NOL computation is determined before or after any pre-2018 NOL carryovers. More guidance is needed on this issue. Example 1. Bill is single and operates a farm in South Dakota. In 2018, Bill’s farming operation experienced a $750,000 loss from the farming activity and from the sale of farm equipment. Bill can carry back $250,000 of the loss to 2016 under the 2-year carryback provision. The remaining $500,000 loss carries forward to 2019. If, in 2019, Bill has $450,000 of taxable income from his farming activity, he can offset the $450,000 of income with $360,000 (80% of $450,000) of loss carryover. Thus, Bill will have $90,000 of income subject to tax in 2019. The remaining $140,000 of unused loss carries over to 2020.

2 IRC §461(l). 3 For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the Commodity Credit Corporation. In that case, farm losses were limited to the greater of $300,000 or net profits over the immediately preceding five years with any excess losses carried forward to the next year on Schedule F (or related form). 4 IRC §172(b)(2). 5 IRC §§172(b)(1)(A) and (B).

CASH ACCOUNTING METHOD The cash accounting method is allowable for taxpayers with annual average gross receipts that do not exceed $25 million for the three prior taxable year periods (the “$25 million gross receipts test”).6 The $25 million amount is indexed for inflation for tax years beginning after 2018. The provision expands the availability of the cash method for farming C corporations (and farming partnerships with a C corporation partner) to include any farming C corporation (or farming partnership with a C corporation partner) that meets the $25 million gross receipts test. The provision retains the exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations. Thus, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of the cash method clearly reflects income. In addition, the provision also exempts certain taxpayers from the requirement to keep inventories. In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership. The $25 million threshold does not apply to tax shelters.7 A tax shelter includes any syndicate. A syndicate is any partnership or other entity (other than a C corporation) if more than 35 percent of the losses are allocable to limited partners or limited entrepreneurs.8 A limited entrepreneur is a person who does not actively participate in the management of an enterprise.9 Farmers that are not C corporations and not partnerships with C corporation partners may use the cash method regardless of gross receipts. However, a C corporation is not considered a C corporation for this purpose if it meets the gross receipt test.

Note. This provision allows the partnership that is not a related party under the aggregation tests in I.R.C. §448(c)(2) to have gross receipts substantially in excess of $25 million (i.e., the threshold, indexed for inflation). The cash method is not prohibited for partnerships without a C corporation partner. The C corporation is not a C corporation for this purpose unless it meets the gross receipts test.

The partnership’s gross receipts are not tested for purposes of Sec. 447. The corporate partner’s gross receipts are measured to determine if it is a corporation for Sec. 447 purposes. In any case where it is necessary to determine the gross income of a partner, gross income includes the partner’s distributive share of the gross income of the partnership.10 Likewise, each partner must also take into account separately the partner’s distributive share of any partnership item which, if separately taken into account by any partner, would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately. Thus, the corporation’s gross receipts are determined by adding the corporation’s gross receipts to the corporation’s share of the partnership’s gross receipts. If the corporate partner’s gross receipts, as determined above, do not meet the gross receipts test, the partnership with the C corporation partner may use the cash method of accounting, even though the partnership’s gross receipts exceed the $25 million threshold.

6 TCJA, Sec. 13102, modifying IRC §448(c). 7 I.R.C. §448(a). 8 I.R.C. §1256(e)(3)(C)(i). 9 I.R.C. §461(j)(4). 10 I.R.C. §702(c).

BUSINESS INTEREST

For tax years beginning after 2017, deductible business interest is limited to business interest for the tax year plus 30% of the taxpayer’s adjusted taxable income for the tax year that is not less than zero.11 Business interest income is defined as the amount of interest that is included in the taxpayer’s gross income for the tax year that is properly allocable to a trade or business. It does not include investment income within the meaning of IRC §163(d). Adjusted taxable income is defined as the taxpayer’s taxable income computed without regard to any item of income, gain, deduction or loss that is not properly allocable to a trade or business; any business interest expense or business interest income; any NOL deduction and any IRC §199A deduction, and (for tax years beginning before 2022) any deduction allowable for depreciation, amortization, or depletion.

Any disallowed amount is treated as paid or accrued in the succeeding tax year. However, businesses entitled to use cash accounting (i.e., average gross receipts don’t exceed $25 million for the three prior tax years) are not subject to the limitation. Thus, if average gross revenues are $25 million or less, there is no change in the rules concerning the deductibility of interest. An electing farm business (as defined by IRC §263A(e)(4)) that is barred from using cash accounting can elect to not be subject to the limitation on the deductibility of interest. In return, such farm business (not cash rent landlords) must use alternative depreciation on farm property with a recovery period of 10 years or more. However, the election out will result in the inability to take bonus depreciation on otherwise eligible assets (in accordance with IRC §263A).

SHOULD PURCHASED LIVESTOCK BE DEPRECIATED OR INVENTORIED? Overview While purchased livestock that is held primarily for sale must be included in inventory (along with all items that are held for sale or for use as feed, seed, etc., that remain unsold at the end of the year), livestock that is acquired (e.g., purchased or raised) for draft, breeding or dairy purposes may be depreciated by a farmer using either the cash or accrual method of accounting, unless the livestock is included in inventory. Treas. Reg. §1.167(a)-6(b). Cash basis farmers and ranchers are allowed to currently deduct all costs of raising livestock, thus only purchased livestock are required to be capitalized and held in inventory or depreciated. Section 1231 Assets I.R.C. §1231 refers to depreciable business property that has been held for more than one year, and includes buildings and equipment, timber, natural resources, unharvested crops, and livestock among other types of business assets. One benefit of I.R.C. §1231 is that gains and losses on I.R.C. §1231 property are netted against each other in the same manner as capital gains and losses except that a net I.R.C. §1231 gain is capital in nature (e.g., taxed at a preferential rate), but a net I.R.C. §1231 loss is treated as an ordinary loss. A special provision in I.R.C. §1231(b)(3) requires that cattle and horses held for draft, breeding, dairy or sporting purposes must be held for at least 24 months to qualify for I.R.C. §1231 status. Other livestock is only required to be held for at least 12 months. It does not include, for example, inventory and property held for sale in the ordinary course of business.

11 TCJA, Sec. 13301, modifying IRC §163(j). For a partnership, the business interest limitation applies at the partnership level. Any business interest deductions are considered in determined the partnership’s non-separately stated taxable income or loss. Each partner’s adjusted taxable income is determined without regard to the partner’s distributive share of any of the partnership’s items of income, gain, deduction, or loss.

I.R.C. §1231 tax treatment is not available if the taxpayer includes livestock in inventory. However, a farmer might have animals listed in the closing inventory in a year that are then transferred to the depreciation schedule in the next year upon the animals reaching maturity and becoming productive. In that event, the inventory value of the animals in the first year’s closing inventory should be subtracted from the beginning inventory for the subsequent year. Even some livestock that does not come within the category of I.R.C. §1231 is depreciable. For example, poultry held for more than one year for breeding or egg-laying purposes may be depreciated if not held primarily for resale. Treas. Regs. §§1.167(a)-3; 1.167(a)-6(b). But, livestock held for sporting purposes is not made specifically depreciable. See Treas. Reg. §1.167(a)-6(b). However, sporting assets may be depreciated as business assets. Sheep and furbearing animals have been held to be I.R.C. §1231 assets. That at least implies that the animals would be depreciable. See Treas. Reg. §§1231-1; 1.1231-2(a)(3). One case, however, has disallowed depreciation deductions for sheep held for breeding, wool and resale purposes. Belknap v. United States, 55 F. Supp. 90 (W.D. Ky. 1944). Depreciate or Include in Inventory – That is the Question The key question for a farmer/rancher is whether livestock should be depreciated or included in inventory. The depreciation of livestock is beneficial to the producer for many reasons. First, depreciation is an ordinary deduction and thus reduces the farmer’s net income and self-employment income. Second, although the depreciation taken on the livestock must be recaptured under I.R.C. §1245, this recapture is not subject to self-employment tax for Schedule F and farmers operating in the partnership form. Third, the amount of gain in excess of original cost, if held for the applicable period, is taxed at favorable capital gains rates under I.R.C. §1231. ------Example: Farmer Jones purchases a cow for breeding purposes and pays $2,000 on January 1, 20X1. Over the next three years, Farmer Jones takes $1,160 of depreciation on the cow, thus reducing his farm income and self- employment income by this amount. He then sells it for $3,000 on January 1, 20X4. At that time, Farmer Jones is required to recapture the $1,160 of depreciation originally taken on the cow at ordinary income tax rates (however, it is not subject to self-employment tax) and the $1,000 gain in excess of original cost of $2,000 is subject to long-term capital gains rates since he held the cow for more than two years. ------So, is this a better tax result than capitalizing the cow and holding it in inventory? The answer turns on whether a current deduction for depreciation will outweigh subsequent capital gain treatment upon sale. Also, that eventual capital gain treatment will be limited by depreciation recapture which means that ordinary income rates will apply to the portion of the gain on sale attributable to the amount of depreciation previously claimed. What About Accrual Basis Taxpayers? In general, if an accrual basis farm taxpayer wants to achieve a lower tax rate on future gains from the qualified sale of breeding, draft, dairy or sporting livestock, livestock should generally be inventoried at the lowest possible value. If that is done, care should be taken in selecting the inventory method that is utilized. Because any particular animal’s inventory value pegs its basis for the computation of gain or loss on sale, the inventory method impacts the ordinary gain on sale. Thus, any method that assigns a relatively low value to an animal will result in a relatively greater ordinary gain upon the animal’s sale. Remember, any livestock held for sale that is not breeding, draft, dairy or sporting livestock is subject to ordinary income

66 tax rates, regardless of the period of time held. It is only livestock held for breeding, draft, dairy or sporting purposes that qualify for long-term capital gain rates under I.R.C §1231.

Here are the available methods, and whichever one is utilized must conform to generally accepted accounting principles and must clearly reflect income.

 Cost method. This method simply values inventory at its cost, including all direct and indirect costs.

 Lower-of-cost-or market method. This method compares the market value of each animal on hand at the inventory date with its cost, and uses the lower of the two values as the inventory value for that animal.

 Farm-price method. This inventory method values inventories at market price less the direct cost of disposition. If this method is utilized, it generally must be applied to all property that the taxpayer produces in the taxpayer’s trade or business of farming – except for any livestock that are accounted for by election under the unit- livestock-price method of accounting.

 Unit-livestock-price method. Under this method of inventorying livestock, the livestock are classified into groups based on age and kind and then the livestock in each group (class) is valued by using a standard unit price for each animal in that class. Essentially, the taxpayer divides the livestock into classifications that are reasonable based on age and kind, with the unit prices for each class accounting for the normal costs of producing and raising those animals. If purchased livestock are not mature, the cost of the livestock must be increased at the end of each year in accordance with the established unit prices, except for animals acquired during the last six months of the year. This can result in a situation where the taxpayer receives a current deduction attributable to the costs of raising the livestock without any additional unit increase in the animal’s closing inventory.

When an animal is included in inventory at its unit price at maturity, its inventory value cannot be written down later to reflect a decline in its value because of, for example, a loss in value due to aging irrespective of whether the animal has not yet reached marketable age. Conclusion For taxpayers that anticipate generating significant income from the sale of draft, dairy or breeding livestock and who inventory livestock, an inventory method (such as the lower of cost or market method and the unit- livestock-price method) that maximizes capital gain on sale rather than income in the years preceding sale will likely be beneficial. However, consideration should be given to the principle that inventorying livestock will usually cause a reduction in current deductions against ordinary income. On the other hand, for livestock that are depreciated, depreciation deductions previously taken are recaptured as ordinary income upon sale of the livestock, but this income is not subject to self-employment tax and the amount of gain in excess of original cost is subject to favorable long-term capital gains treatment.

LIKE-KIND EXCHANGES (POST TCJA) I.R.C. §1031 allows a tax-deferred exchange of property held for productive use in a business or property held for investment if the replacement property is like-kind property held for those purposes. Before 2018, the like-kind exchange rules applied to real property, tangible personal property, and certain intangible property. For tax years beginning after 2017, personal property and intangible property has been removed from I.R.C. §1031. Thus, for exchanges completed after 2017, I.R.C. §1031 is limited to real property exchanges.12 Like-kind exchanges of personal property are taxable. Federal income tax law, rather than state law, controls whether exchanged properties are of like-kind for purposes of I.R.C. §1031. I.R.C. §§48, 263A and 1245 are informative on whether property is real property or personal property for federal income tax purposes.13 Observation. The sale of a farm as part of a deferred exchange requires the determination of real vs. personal property status. For I.R.C. §1031 purposes, it is necessary to determine if machinery and equipment are structural components to an inherently permanent structure. That status is determined based on whether the structure remains intact if the equipment is removed. Under Treas. Reg. §1.263A-8(c), real property includes the following:  Land;  Unsevered natural products of land;  Buildings and inherently permanent structures;14  Machinery that is a structural component to a building or inherently permanent structure.15

Tangible personal property means any tangible property except land and improvements, including structural components of such buildings or structures. The following are examples of tangible personal property as noted in Treas. Reg. §1.48-1(c):

 Production machinery;  Printing presses;  Transportation and office equipment…contained in or attached to a building;  Gasoline pump;  Hydraulic car lift; and  Automatic vending machine (even though annexed to the ground).

Example. Blanche Carte owns hog confinement facilities consisting of a structure, hopper feeder bins, augers and feeders, and manure storage. The hopper feeder bins, augers and feeders are designed to function as an integrated unit and can be removed without damage to the integrity of the overall structure. Thus, they are considered to be personal property. Blanche also owns a feed handling facility that includes corrugated steel grain silos, an elevator leg with downspouts, dump pit, together with feed grinding and mixing equipment. Except for the feed grinding and mixing equipment, these assets are real property assets.

12 I.R.C. §1031(a)(1). 13 C.C.A. 201238027 (Apr. 17, 2012). In the CCA, IRS state that, “Relying solely on state property classifications can lead to absurd results.” Identical property exchanged across state lines would not qualify for I.R.C. §1031 if the property happened to be located in states which classified the property differently. 14 Inherently permanent structures include property affixed to real property and that will ordinarily remain affixed for an indefinite period of time, such as swimming pools, roads, bridges, tunnels, telephone poles, broadcasting towers and storage equipment. 15 Id.

Simply because the TCJA eliminates tax-deferred exchange treatment for tangible personal property does not mean that a farmer will no longer engage in like-kind exchanges involving property other than real estate. Farmers will still “trade” equipment. However, the tax reporting is handled differently from how it was reported before the effective date of the TCJA provision. For personal property trades completed after 2017, the trade-in value will be listed as the “selling price of the “traded” equipment on Form 4797. Consequently, the entire asset value will be added to the depreciation schedule and would be eligible for bonus depreciation or I.R.C. §179.

Example.16 George traded his tractor for a new tractor in 2017. Based on the pre-TCJA version of I.R.C. §1031 as applied to trades of tangible personal property, and assuming that George is trying to get his taxable income at $77,400 (which happens to be the top of the 12 percent tax bracket for 2018) the transaction would be treated as follows on George’s 2017 return:

Frank Farmer – Prior Law Farm Income (before depreciation) $250,000 Old Tractor Trade Allowance $150,000 New Tractor Trade Difference (boot) $250,000

Farm Income 250,000 4797 Gain 0 ∲ 179 Deduction 131,053 Schedule F 106,203 1st Year Depreciation 12,744 ½ SE Tax 7,503 Schedule F 106,203 AGI 98,700

New Purchases 250,000 SD & Exemptions 21,300 Less ∲ 179 Deduction -131,053 Taxable Income 77,400 Remaining Cost 118,947 Income Tax (10% & 15%) 10,658 7-YR 150% DB X 10.714% SE Tax 15,006 1st Year Depreciation 12,744 Total Liability 25,664

Thus, under pre-TCJA law and assuming the target is to have taxable income at $77,400, the transaction results in no gain being reported on Form 4797, an I.R.C. §179 deduction of $131,053 and regular MACRS depreciation of $12,744. Self-employment tax liability of $15,006 is off-set by the deduction for one-half of that amount. George’s total tax liability is $25,664.

16 This example is contributed by Mark Dikeman, Associate Director, Kansas Farm Management Association, Kansas State University.

Now, assume that George trades his tractor in 2019. The transaction doesn’t qualify for tax-deferred treatment under I.R.C. §1031, but that doesn’t mean that his resulting tax liability is higher. Again assuming that George is targeting $77,400 of taxable income, the transaction is reported as follows:

Frank Farmer – TCJA Farm Income (before depreciation) $250,000 Old Tractor Trade Allowance $150,000 New Tractor Trade Difference (boot) $250,000

Farm Income 250,000 4797 Gain 150,000 ∲ 179 Deduction 249,063 Schedule F (29,250) 1st Year Depreciation 30,187 ½ SE Tax 0 Schedule F (29,250) AGI 120,750 Standard Deduction 24,000 New Purchases 400,000 ∲ 199A Deduction 19,350 Less ∲ 179 Deduction -249,063 Taxable Income 77,400 Remaining Cost 150,937 Income Tax (10% & 12%) 8,907 5-YR 200% DB X 20.000% SE Tax 0 1st Year Depreciation 30,187 Total Liability $8,907

In 2019, the transaction results in the $150,000 of the trade allowance for the old tractor being reported as gain on Form 4797. The $400,000 price of the new tractor is fully depreciable with the total depreciation deduction for the year (I.R.C. §179 and MACRS) is $279,250. There is no longer any self-employment tax on the transaction. George’s AGI is now $120,750. After the standard deduction, the new QBI deduction of I.R.C. §199A is $19,350. The applicable income tax rates are now 10 percent and 12 percent, and George’s final tax liability is $8,907. Thus, the resulting tax liability in 2019 is $16,757 less than the same transaction in 2017. This difference is attributable to a larger depreciation deduction, elimination of self- employment tax and a QBI deduction. Impact on Social Security benefits. The elimination of I.R.C. §1031 treatment for personal property exchanges completed after 2017 may prevent many farmers from showing any self-employment earnings if they trade farm equipment during the year. For these farmers, one approach is to elect the optional self- employment method. Thus, even if a loss is reported on the return, the optional method will allow the taxpayer to “report” $5,280 of self-employment income. This will result in additional self-employment tax of approximately $808, but will allow the taxpayer to at least show this amount of income for Social Security retirement purposes. It will also create $5,280 of “earned income” for purposes of claiming the earned income tax credit or child tax credit. Another approach might also be tax effective for farm taxpayers that reside in a state that does not require sales tax on farm equipment. In these states, the taxpayer could transfer all of the farm equipment to an S corporation and have all of the trade-ins incur inside of the corporation. In this situation, both the gain from trading in equipment and the resulting 100 percent bonus depreciation on the new equipment is all reported inside of the corporation and will not affect social security earnings. Additionally, the taxpayer could then receive a wage for properly managing the operations of the corporation. This would help the taxpayer build- up his social security retirement benefits and provide additional legal protection in case of equipment accidents. Of course, however, an additional return would need to be filed and additional payroll would need to be performed.

Note. The TCJA expanded I.R.C. §1031 treatment to cover a partnership interest where the partnership has made an election under I.R.C. §761(a) to exclude the entity from partnership treatment under Subchapter K. The partnership interest is then considered to be an interest in each of the partnership’s assets. To the extent that those assets are real property, they are eligible for I.R.C. §1031 treatment.

COST SEGREGATION

Overview. Often a real property asset (e.g., land with improvements or a building) contains associated items of personal property. Cost segregation is the practice of taking such assets and splitting associated structural component parts into a group or groups of smaller assets that can be depreciated over shorter lives.17 Firms performing cost segregation studies commonly utilize professionals with valuation skills, knowledge of construction methods, materials and costs, and a knowledge of the applicable income tax rules. This provides the needed technical support for determining whether a particular item of property should be allocated (either in whole or in part) to a function that will allow it to be classified as tangible personal property. A primary emphasis of a cost segregation study is to classify assets as depreciable personal property rather than as depreciable real estate (or classify depreciable personal property (e.g., structures) separate from non-depreciable real estate). In tax lingo, a cost segregation study often results in the construction of rather detailed lists of individual assets that distinguish I.R.C. §1245 property with shorter depreciable recovery periods from I.R.C. §1250 property that has a longer recovery period.18 This purpose of a cost segregation study is to generate larger depreciation deductions in any particular tax year.

Observation. According to the American Society of Cost Segregation Professionals, a cost segregation is "the process of identifying property components that are considered "personal property" or "land improvements" under the federal tax code." Cost segregation is the engineering and accounting process of identifying those items of personal property that are contained within real property, and separating out the items of personal property for MACRS purposes. Land is not depreciable, but structures associated with land are. From a depreciation standpoint, that means that there may be opportunities to allocate costs to personal property or land improvements that are depreciable.

Note. The Tax Cuts and Jobs Act (TCJA) of late 2017, at least indirectly, makes the practice of cost segregation more beneficial by providing for the immediate expensing of up to $1 million ($1,020,000 for 2019) of most personal property that is found on commercial and business property (including property found on a farm or ranch), and also by allowing first-year 100 percent “bonus” depreciation on used (in addition to new) assets. These changes make it more likely that a cost segregation study will provide additional tax benefits.

Cost segregation study procedure - in general. A cost segregation study, generally begins with a site inspection leading to a determination of the total income tax basis for the property at issue – particularly the land value. Once the land value is determined, the study will determine the value of personal property, taking into account wear and tear. Those items of personal property with assigned values will be listed. Listed separately will be land improvements and the value assigned to them. Some land improvements will be worth more than original cost – trees become full grown, for example. Other land improvements will

17 See Treas. Reg. §1.48-1(e)(2)(provides guidance on the definition of a “structural component”). 18 See, e.g., Hospital Corporation of America & Subsidiaries, 109 T.C. 21 (1997), acq. and non-acq. 1999- 35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763. But see, Amerisouth XXXII, Ltd. v. Comr., T.C. Memo. 2012-67 (involving residential rental property).

71 be worth less than original cost due to wear and tear. Once the personal property and land improvements are segregated and valued, if a building is involved the remaining depreciable value is assigned to the building. All values are assigned using acceptable cost estimates, and appropriate unit factor prices and/or multipliers should be used to fine tune the values in accordance with location, deflation and depreciation. Worksheets will then be prepared, with each asset broken out into the appropriate asset class and a value assigned to it. The asset classes and associated depreciable lives for personal property and land improvements will be in accordance with Rev. Proc. 87-56.19 Purpose and goal of a cost segregation study. As noted, a cost segregation study is the name of the process that is used to identify and reclassify as tangible personal property structural components that have shorter MACRS recovery periods than the structures in which they are contained in order to achieve accelerated depreciation deductions. For example, the classification and separation of assets into those with shorter class lives (such as 5, 7 10 or 15 years) than a building (such as 20, 27.5 or 39-year MACRS property) instead of including those assets with the building for depreciation purposes, is done with the purpose of reducing the taxpayer’s current tax liability and increasing cash flow. As a result of a cost segregation study, the structural components of a building are often depreciable over 5-7 years. This would include such items as walls, windows, HVAC systems, plumbing and wiring. Note. While most cost segregation studies involve nonresidential commercial properties, it may be possible with respect to farm buildings to parse out the electrical wiring associated with a dairy parlor or a sow feeding system, for example. For fruit and vegetable farming operations, specialized equipment might be involved or there might also be some type of cooling system involved for a particular space or structure. The goal of a cost segregation study is to find assets that are affixed to the building, but are not involved with the building’s overall operation and maintenance, as well as those assets that are outside of the building structure and affixed to land that also don’t relate to the building’s operation and maintenance (such as land improvements). Note. Land improvements (which are 15-year MACRS property) include parking lots, driveways, paved areas, site utilities, walk ways, sidewalks, curbing, concrete stairs, fencing, retaining walls, block walls, car ports, dumpster enclosures, and landscaping. Landscaping can be broken down into plants, trees, shrubs, sod, mulch, rock and security lighting.20 For agricultural land, improvements include such things as pumps and wells that have been installed for irrigation purposes; fences; stock-watering ponds; earthen dams; soil conservation terraces; roads; fences and gates; drainage ditches and; water diversion channels.

Example. Assume that a building is acquired along with the purchase of a tract of real estate. If the tract was purchased for $500,000 and 100,000 was allocated to the building, that $100,000 would be depreciated over 27.5 or 39 years. That would generate an annual depreciation deduction. But, it may be the case that a cost segregation study could result in more of the cost allocated to the building to be allocated to depreciable property contained within the building with shorter depreciable lives. If so, the depreciation deductions associated with the building and the items in the building will be enhanced. Breaking items out like this can also make it easier to make a partial asset disposition election and aid in deducting removal costs.

Allocation between I.R.C. §1245 and I.R.C. §1250 property. Distinguishing between I.R.C. §1245 property and I.R.C. §1250 property via a cost segregation study is important because first-year bonus depreciation is presently set at 100 percent of a qualified asset’s cost basis through 2022. To be qualified property, the MACRS rules must apply to it with a recovery period of 20 years or less. That means that I.R.C. §1250 property that is a non-residential building (and the building’s structural components) won’t

19 1987-2 CB 674. 20 https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents.

72 qualify for bonus depreciation because the building is 39-year recovery property under MACRS.21 By contrast, most types of I.R.C. §1245 property is tangible personal property that is eligible for bonus depreciation under I.R.C. §168(k) as well as expensing under I.R.C. §179.22

In determining whether an item is a structural component, the courts tend to look at the ultimate use of an item. If an item’s ultimate use is for the operation and maintenance of a building, it is not tangible personal property. If, however, an item’s ultimate use is directly applicable to the operation of an item of tangible personal property, then the item is treated as tangible personal property. This is, in effect, a use by the courts of the “sole justification” exception contained the definition of structural at Treas. Reg. §1.48-1(e)(2). Although the sole justification exception as described in the regulations appears to apply only to machinery required to meet temperature or humidity requirements essential for the operation of other machinery or the processing of materials, the courts have held that there is no such limitation. The sole justification exception therefore applies to any items found in a building. Under the sole justification exception, if the sole reason for the existence of an item is the fact that it services or relates to an item of tangible personal property, the item will also be treated as tangible personal property, even if it incidentally or insubstantially serves operational and maintenance needs of a building. Example. Air-conditioning is required to keep the temperature of a computer room low to help prevent overheating of computer components. The fact that the air-conditioning also incidentally cools employee work space would not prevent the air-conditioning from being treated as tangible personal property because the sole justification for the air-conditioning is cooling equipment, which is tangible personal property. It appears that the Tax Court’s interpretation of the sole justification exception is one under which if there is only insubstantial support of operations and maintenance the entire item will be treated as tangible personal property. Conversely, if there is only an insubstantial relationship between the item and an item of tangible personal property, no portion of the item will be treated as tangible personal property. If, however, an item both contributes to the operation and maintenance of a building and to the support of an item of tangible personal property and neither use is insubstantial in relation to the other, the Tax Court will permit an allocation of costs for §38 purposes. For example, in Hospital Corporation of America & Subsidiaries,23 the Tax Court held that the classification of property as real property or tangible personal property (i.e., distinguishing I.R.C. §1245 from I.R.C. §1250 property) for purposes of MACRS is to be determined on the basis of what the property’s classification would have been for purposes of the (now repealed I.R.C. §48) investment tax credit (ITC).24 Under the ITC rules, if a component of a building satisfied certain requirements, it would be classified as tangible personal property rather than as part of the permanent building or its structural components, thereby entitling its basis to be recovered as tangible personal property through accelerated MACRS depreciation rather than as a straight-line real property.25 However, some courts have held that even if an item of property

21 Some types of land improvements, while having a 15-year recovery period, are eligible for bonus depreciation even though they are I.R.C. §1250 property. 22 There is no statutory definition of “personal property” for depreciation purposes. The regulations state that the term is to be defined in the same manner as “tangible personal property” is defined under Treas. Reg. §1.48-1(c) concerning property eligible for the (presently repealed) investment tax credit. Treas. Reg. §1.1245-2(b)(1). 23 109 T.C. 21 (1997), acq. and non-acq,. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763. 24 Property that was eligible for the ITC was referred to generally as “section 38 property.” 25 However, some courts have held that even if an item of property is listed in Treas. Reg. §1.48-1(e)(2) as being a structural component, it is not a structural component of a building to the extent that the item does not relate to the operation or maintenance of the building. See, e.g., Scott Paper Co. v. Comr., 74 T.C. 137

73 is listed in Treas. Reg. §1.48-1(e)(2) as being a structural component, it is not a structural component of a building to the extent that the item does not relate to the operation or maintenance of the building.26 In addition, the IRS has determined that the ITC classification of property is not controlling for purposes of interest capitalization under I.R.C. §263A(f).27

Observation. Together, the cases and the regulations seem to indicate that if component elements that are classified as tangible personal property as a result of a cost segregation study otherwise constitute buildings or structural components thereof, reclassified components will still be treated as real property for purposes of the like-kind exchange rules of I.R.C.§1031.

If property is inherently permanent, it is generally not treated as tangible personal property. While perhaps the most important factor, movability (by itself) is not the controlling factor in deciding whether property lacks permanence. The fact, however, that an item is not readily reusable in another location is evidence supporting the conclusion that it is to be treated as permanent in its present location. The Tax Court has set forth six factors for analyzing whether property is inherently permanent:28  Whether the property is capable of being moved, and has in fact been moved;  Whether the property is designed or constructed to remain permanently in place;  Whether there are circumstances which tend to show the expected or intended length of affixation (i.e., whether there are there circumstances which show that the property may or will have to be moved);  The effort and time commitment needed to remove the property;  The extent of damage the property can be expected to sustain upon removal, and;  The manner in which the property is affixed to the land.

Observation. Breaking out and identifying items that are depreciable personal property from real estate may also have a property tax benefit with respect to agricultural-related assets. In some states, farm personal property is not taxed for real estate purposes. Thus, if the items of depreciable personal property are broken out with a value assigned to them, real estate taxes may drop.

Accounting method. When the MACRS class life of an asset is changed, a change in accounting method is triggered which requires the IRS consent. However, the change of classification of an asset from I.R.C. §1250 real property to I.R.C. §1245 tangible personal property is within the automatic consent provisions of Rev. Proc. 2018-40.29 Under this guidance, a taxpayer can change its method of accounting to take claim depreciation deductions on assets that were previously under-depreciated. The additional depreciation is

(1980). In addition, property may be considered to be tangible personal property for ITC purposes even though it is classified as real property under state law. Treas. Reg. §1.48-1(c). 26 See, e.g., Scott Paper Co. v. Comr., 74 T.C. 137 (1980). In other words, the ultimate use of the item is key to the distinction. 27 C.C.A. 2000648026 (Aug. 25, 2006). 28 Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975). 29 2018-34 IRB, updating and modifying Rev. Proc. 2018-31 and Rev. Proc. 2017-30. Form 3115 must be attached to the return for the year of the change. Technically, IRS is not required to accept the change and may notify the taxpayer that the change is rejected. In that event, the taxpayer must utilize the original method of accounting, submit a formal ruling request, and pay the applicable user fee.

74 treated as a negative I.R.C. §481(a) deduction and is spread over the four-year period starting with the year in which the adjustment is made.30

A “look-back” cost segregation study may also be used to identify missed deductions from prior years. Form 3115 (application for a change in accounting method) must be filed with the IRS to claim these “catch- up” deductions on the current year return. This can also be beneficial in certain circumstances in dealing with the limitations on deducting net operating losses under the post-2017 rules.

Purchase price allocation rules and cost segregation. When business assets are sold, the parties often negotiate and allocate the purchase price among the various assets. Generally, the buyer wants a significant portion of the purchase price allocated to depreciable assets in order to claim depreciation deductions over a shorter period of time (usually three to seven years depending upon asset type). The seller, on the other hand, may want the purchase price allocated primarily to intangible assets such as company goodwill, which generally results in a lower tax obligation. Because of these competing interests, the IRS generally respects the negotiated purchase price allocations of the parties if they follow the special asset allocation rules set forth in I.R.C. §1060. I.R.C. §1060 prescribes special allocation rules for determining a transferee's basis and a transferor's gain or loss in an asset acquisition. Under Section 1060(c), an applicable asset acquisition is any transfer of assets that constitutes a trade or business when the purchaser's basis in the assets is determined to be wholly referenced to the consideration paid for them.

For an applicable asset acquisition, both the seller and the buyer must allocate the consideration paid among the assets transferred. The method of allocation is substantially the same as the residual allocation method required under I.R.C. §33831 when an election is made to treat the liquidation of a subsidiary corporation as a taxable acquisition of its assets, and which is cross-referenced under the I.R.C. §1060 regulations as being applicable for that purpose.

The residual allocation method identifies the following classes of assets among which consideration must be allocated:  Class I assets are cash, deposits in banks, and similar items.  Class II assets are certificates of deposit, U.S. Government securities, certain marketable stocks and securities, foreign currency, and similar items.

 Class III assets are accounts receivable, assets a taxpayer marks-two-market at least annually for tax purposes, mortgages, and credit card receivables from customers that arise in the ordinary course of business.

 Class IV assets are stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.  Class V assets are all assets other than those assigned to any other class.

 Class VI assets are all § 197 intangibles except goodwill and going concern value.

 Class VII assets are goodwill and going concern value.

30 Because the change is subject to the automatic consent rules, no ruling request is required and no user fee need be paid. 31 See also Treas. Reg. § 1.338-6.

Consideration is first allocated to Class I assets. After the consideration is reduced by the amount allocated to Class I, it is allocated among Class II assets in proportion to their fair market values as of the purchase date, then among Class III assets in proportion to their fair market values and in a like manner down to Class VI assets in proportion to their fair market values. Any unallocated consideration remaining after allocation among the Class VI is allocated to the Class VII assets, which are goodwill and going concern value. If the parties to an applicable asset acquisition agree in writing to allocate any part of the purchase price to the acquired assets, or to the fair market value of any of the transferred assets, I.R.C. §1060(a) specifies that the agreement is binding unless the IRS determines that the allocation or fair market value is not appropriate. Deviation from the written agreement is permissible only if the taxpayer can establish that the agreement would be unenforceable under state contract law due to such things as mistake, undue influence, fraud, or duress.32 However, the IRS may challenge a taxpayer’s determination of the fair market value of any asset by any appropriate method, taking into account all factors, including any lack of adverse tax interests between the parties.

Note. Both the seller and the buyer must file Form 8594, Asset Acquisition Statement under Section 1060, with their returns for the tax year that includes the purchase date.

However, if the parties do not agree in writing to allocate any part of the purchase price to the acquired assets, then the residual method of I.R.C. §338(b)(5) and Treas. Reg. §1.338-6(b) determines the buyer's basis in, and the seller's gain or loss from, each of the transferred assets. Under this method the acquired assets are categorized among seven different asset classes (cash and cash equivalents, actively traded personal property, debt instruments, inventory, other assets not in the foregoing classes, intangibles, goodwill, and going concern value) and the purchase price is allocated to the asset classes according to the priority established by the regulations.

There is a link between a purchase price allocation that I.R.C. §1060 requires for an applicable asset acquisition and cost segregation. This is evidenced in post-transaction situations when the parties either forget or choose to disregard their contractual allocations, subsequently conduct an audit, and assign values to the acquired assets based on generally accepted accounting principles (GAAP), and report tax consequences using the newly determined values rather than the previously agreed-upon contractual allocations. For example, in Peco Foods, Inc. & Subsidiaries v. Comr.,33 the parent corporation, through two of its subsidiaries, acquired the assets of two poultry processing plants for about $38 million during the 1990s. Each agreement allocated the purchase price of the assets among the two subsidiaries and further allocated the price among various assets in accordance with allocation schedules in the contractual agreements which depreciated the real improved real property over 39 years. Later, the corporation arranged for a cost segregation analysis of the two plants, further subdividing certain acquired assets into subcomponents. The analysis determined that subdividing these assets would entitle the corporation to additional depreciation expense (by reclassifying portions of the real property as tangible person property) of about $5.26 million. The corporation filed a request for a change in accounting method and claimed depreciation on its tax returns in accordance with the cost segregation analysis. The corporation deducted negative I.R.C. §481 adjustments and accelerated MACRS depreciation for the reclassified assets.

32 See, e.g., Comr. v. Danielson, 378 F.2d 771 (3rd Cir. 1967), cert. den., 389 U.S. 858 (1967). 33 T.C. Memo. 2012-18, aff’d., 522 Fed. Appx. 840 (11th Cir. 2013).

The IRS audited the parties’ returns and disallowed the deductions based on the reclassifications. The Tax court agreed, holding that under I.R.C. §1060(a), the corporation was bound by the written allocation schedules that were agreed upon by the parties to the transaction. The Tax Court further found no ambiguity in the original allocations that would warrant further subdividing the assets into subcomponents in accordance with the cost segregation study. Thus, the Tax Court disallowed the accounting method change and required the corporation to claim depreciation in accordance with the original allocation schedules.

The Tax Court noted that its holding barred the government from being disadvantaged by inconsistent treatment of the parties to the transaction. In addition, even if there was no possibility of inconsistent tax treatment, the court reasoned that "binding Peco to the original ... allocation schedule[s] prevents it from realizing a better tax consequence than the one it bargained for." The Tax Court’s decision was affirmed on appeal.

Observation. The lessons to be learned from Peco Foods are two-fold. First, taxpayers, that have agreed in writing to certain purchase price allocations cannot unilaterally change the original allocations to achieve a better tax result. This is in accordance with I.R.C. §1060(a), taxpayers will be bound by their original allocations of the purchase price or as to the fair market value of any of the transferred assets, unless the IRS determines that the allocation or fair market value is not appropriate. Second, because both real property and depreciable tangible personal property are Class V assets and no further breakdown is required on Form 8594, the purchase price should not be allocated other than is necessary to ensure consistent reporting by the parties to the transaction on Form 8594. Allocation is to be by class, not by specific assets.

Potential recapture issue. When a component of I.R.C. §1250 property is reclassified as § 1245 property, the total depreciation allowable on the reclassified item is the same. The benefit comes from the present value of the tax savings resulting from the acceleration of the depreciation deduction. However, depreciation recapture can occur on disposition. Depreciation on an I.R.C. §1245 asset is subject to ordinary income recapture in accordance with I.R.C. §1245 and is ineligible for long-term capital gain treatment under I.R.C. §1231. The impact of this result depends on the particular taxpayer’s marginal tax bracket at the time the recaptured amount is taxed. If the item of property had not been reclassified, gain on it would have been subject to a maximum rate of 25 percent as unrecaptured I.R.C. §1250 depreciation. Thus, the ordinary income penalty could be deminimis or it could be as much as 37 percent for individuals (but only 21% for C corporations).

The recapture issue may be more problematic if the disposition of the reclassified asset is via installment sale, like-kind exchange or involuntary conversion. Although gain from a sale of I.R.C. §1231 property can be reported on the installment basis, installment reporting is not permitted for I.R.C.§1245 depreciation recapture. Instead, all I.R.C. §1245 recapture is treated as cash received in the year of sale and must be reported.34 The taxpayer’s basis in the property for purposes of calculating the gross profit ratio is then increased by the amount of depreciation recapture and any remaining gain is taxed each year using the recomputed gross profit ratio.

Observation. A taxpayer who has reclassified a significant portion of a property’s basis as I.R.C. §1245 tangible personal property must be careful in an installment sale to get enough cash down to pay the tax liability resulting from the recapture along with any first-year payments. (This may also lead to some creative purchase price allocations in sales contracts.)

34 IRC § 453(i).

Ordinary income recapture under I.R.C.§1245 applies to any disposition of I.R.C. §1245 property notwithstanding any other provision of the Code unless there is an express exception contained in I.R.C. §1245.35 I.R.C. §1245(b)(4) provides a limited exception from the recapture rules for like-kind exchanges under I.R.C. §1031 and involuntary conversions under I.R.C. §1033. Under the exceptions, if property is disposed of and there is nonrecognition of gain under I.R.C. §1031 or I.R.C. §1033, then the amount of gain to be taken into account under I.R.C. §1245 by the seller is not to exceed the sum of the amount of gain recognized on the disposition determined without regard to I.R.C. §1245 (effectively boot received under I.R.C. §1031 and proceeds not reinvested under §1033), plus the fair market value of any property that is received and which is not I.R.C. §1245 property and has not already been taken into account as gain. The application of the application rules in the event a portion of the real property is reclassified as §1245 property is illustrated as follows:36 Example. Sam Sung owns I.R.C. §1245 property, with an adjusted basis of $100,000 and a recomputed basis of $116,000. The property is destroyed by fire and Sam receives $117,000 of insurance proceeds that triggers $16,000 of recapture. Sam uses $105,000 of the proceeds to purchase I.R.C. §1245 property similar or related in service or use to his original property, and $9,000 of the proceeds to purchase stock in the acquisition of control of a corporation owning property similar or related in service or use to Sam’s original property. Both acquisitions qualify under the involuntary conversion rules. Sam properly elects to limit recognition of gain to the amount by which the amount realized from the involuntary conversion exceeds the cost of the stock and other property acquired to replace the converted property. Since $3,000 of the gain is recognized (without regard to the I.R.C. §1245 recapture rules) under the involuntary conversion rules for failure to purchase sufficient replacement property (that is, $117,000 minus $114,000), and since the stock purchased for $9,000 is not I.R.C. §1245 property and was not taken into account in determining the gain under the involuntary conversion rules, the amount of the gain taken into account as I.R.C. §1245 recapture is limited to $12,000 (that is, $3,000 plus $9,000). If, instead of purchasing $9,000 in stock, Sam purchases $9,000 worth of property which is I.R.C. §1245 property similar or related in use to the destroyed property, the recapture amount would be limited to $3,000.37 As noted above, a building containing items that have been reclassified as I.R.C. §1245 tangible personal property for MACRS purposes as the result of a cost segregation study does not change the classification of the property for purposes of the like-kind exchange provisions of I.R.C. §1031 or the involuntary conversion rules of I.R.C. §1033. Consider the following example: Example. Ray Ovac reclassifies 25 percent of the basis of items in a building as being 7-year MACRS property and claims accelerated depreciation. All of the items are otherwise structural components of the building and therefore classified as real property under state law. Ray later trades the building and associated land in a like-kind exchange for unimproved land. For purposes of applying the like-kind exchange rules of I.R.C. §1031, Ray is treated as having traded real property for real property. Ray will recognize gain under I.R.C. §1245, however, unless the FMV of the 25 percent of the basis that was reclassified as I.R.C. §1245 property is replaced by an equal or greater FMV of I.R.C. §1245 property.38

35 I.R.C. § 1245(a)(1). 36 The following example is based on Treas. Reg. §1.1245-4(d)(5). 37 The result of the example would be similar in an I.R.C. §1031 exchange. 38 The point of this is to ensure that the I.R.C. §1245 recapture carries over to the replacement I.R.C. §1245 property and is not subsumed by the replacement I.R.C. §1250 property.

IRS Field Directives. The IRS has issued Field Directives for cost segregation issues in various industries that categorize many assets either as I.R.C. §1250 property or I.R.C. §1245 property. Thus, if a taxpayer takes a position on a return with respect to an asset that follows the guidance of the applicable Directive, an IRS examining agent is not to make adjustments to how the assets are categorized or the recovery period of the assets. The IRS Field Directives for the certain industries can be found as follows:  The IRS cost segregation field directive for casinos can be found here: https://www.irs.gov/businesses/cost-segregation-atg-chapter-7-1-industry-specific-guidance- casinos  The IRS cost segregation field directive for restaurants can be found here: https://www.irs.gov/businesses/cost-segregation-guide-chapter-72-industry-specific-guidance- restaurants  The IRS cost segregation field directive for retail industries can be found here: https://www.irs.gov/businesses/cost-segregation-atg-chapter-7-3-industry-specific-guidance- retail-industries  The IRS cost segregation field directive for pharmaceutical and biotechnology industries can be found here: https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-chapter-74- industry-specific-guidance-pharmaceutical-and-biotechnology  The IRS cost segregation field directive for auto dealers can be found here: https://www.irs.gov/businesses/field-directive-on-the-planning-and-examination-of-cost- segregation-issues-in-the-auto-dealership-industry  The IRS cost segregation field directive for auto manufacturing can be found here: https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-chapter-7-6-auto- manufacturing

Note. An IRS Field Directive is not an official pronouncement of the law or of the position of the IRS. But, they are useful as a guide for classifying assets for building that contain many potential I.R.C. §1245 assets. The fact that the Directives deal with broad classifications of I.R.C. §1245 property provides guidance for property not within an industry that is specifically covered by one of the Directives.

The Directives list the following types of assets as having a shorter recovery period than that applicable to I.R.C. §1250 property in general. Thus, such property is eligible for bonus depreciation if otherwise qualified under I.R.C. 168(k).  Canopies and awnings.  Decorative finished carpentry (detailed crown moldings; lattice work on finished walls, ceiling and cabinets, etc.).  Doors (such as those installed to prevent accidents such as those that are flexible, or are clear curtains, etc.).  Electrical outlets associated with a specific item of machinery or equipment.  Electrical connections that are associated with specific machinery or equipment.  Interior building facades that are not permanently attached.  Fire protection equipment.  Floor coverings that aren’t permanently attached.  Foundations (such as footings to a building or for a sign or light pole).  HVAC systems that are essential for the operation of other machinery.  Kiosks.  Landscaping and shrubbery  Irrigation systems  Decorative lighting that is not necessary for the operation of the building.

 Lighting that highlights landscaping or the building exterior that is not related to the operation or maintenance of the building.  Exterior, pole-mounted lighting for sidewalks and parking.  Music/P.A. system that isn’t part of a fire protection system.  Parking lot and associated items such as bumper blocks, curb cuts, perimeter fences, etc.39  Light poles for parking.  Plumbing for appliances or equipment for a particular type of business (such as a restaurant or hair salon/barber shop).  Security equipment.  Non-permanent signs.  Site grading.  Moveable (partition) walls.  Non-permanent wall coverings.  Window accessories.

Placed-in-service. Cost segregation studies performed contemporaneously with the taxable year that qualified property is placed in service should allow enough time before the tax return for that year is filed to determine the amount of bonus and other depreciation allowable on that property. On the other hand, when a cost segregation study is performed after the tax return is filed for the year the qualified property is placed in service, it is unlikely that the taxpayer claimed bonus depreciation on that property and is using an impermissible method of accounting. Generally, taxpayers can file an amended tax return for the property's placed-in-service year to claim bonus depreciation and adjust the depreciation allowable on the qualified property, provided that the amended tax return is filed before the taxpayer files its tax return for the first taxable year succeeding the placed-in-service year. However, if the first taxable year succeeding the placed-in-service year is already filed before the cost segregation study is performed and the qualified property is identified, the taxpayer has adopted an impermissible method of accounting and must change from an impermissible method to a permissible method by filing a Form 3115.

Observation. Because of the additional depreciation incentives included in the TCJA, the use of cost segregation studies has been further incentivized and understanding the “placed-in-service” date of an asset has risen in of importance.

An asset is deemed to be placed in service when it is in a condition or state of readiness and availability for a specifically assigned function such as use in the taxpayer’s trade or business.40 For example, as applied to a factory building that the taxpayer constructs or reconstructs that is intended to house machinery and equipment, the building is deemed to be placed in service when it is substantially completed and in a condition or readiness and availability. It doesn’t matter that the machinery and equipment has not been placed in the building. The only exceptions to this standard are when the building itself could be deemed to be an item of machinery or equipment, or the building use is so intertwined with the machinery or

39 In Priv. Ltr. Rul. 9751010 (Sept. 12, 1997), the IRS took the position that an open-air parking ramp/tower consisting of an auto carousel mechanism and supporting tower is tangible personal property for purposes of I.R.C. §168. This type of structure could, perhaps, be contrasted with an open-air parking structure accessible by a ramp system which might be 39-year MACRS property. 40 See Treas. Reg. §1.167(a)-11(e)(1)(i). For caselaw on the specifically assigned function issue, see Noell v. Comr., 66 T.C. 718 (1976); Consumers Power Co. v. Comr., 89 T.C. 710 (1987); Valley Natural Fuels v. Comr., T.C. Memo. 1991-341, aff’d, 990 F.2d 1266 (9th Cir. 1993); and Brown v. Comr., T.C. Memo. 2013-275. See also Treas. Regs. §§1.46-3(d)(1)(ii) and 1.46-3(d)(2); Von Kalinowski v. Comr., 45 F.3d 438 (9th Cir. 1994), rev’g. T.C. Memo. 1993-26; Sears Oil Company, Inc. v. Comr., 359 F.2d 191 (2d Cir. 1966).

80 equipment that the building could be expected to be retired or replaced when the machinery or equipment that it houses is replaced or retired.41 When does the business begin? If a business asset is acquired before the business has begun, depreciation deductions are not available until the business starts, regardless of whether the asset is ready and available for use in the business. A plan or intention of starting a business is not enough, and it is important to distinguish between an ongoing business that is idle and a future business that has not yet begun.42 But, when the business does eventually begin the IRS may dispute when the business actually began. In Piggly Wiggly Southern, Inc. v. Comr.,43 the petitioner, a grocery store, claimed depreciation on equipment that it had in various grocery stores. Some of the stores were being renovated. Others were new stores. The court held that the petitioner was not entitled to depreciation deductions attributable to equipment located in the new stores until those stores actually opened for business. The court noted that the petitioner controlled when the new stores opened rather than the opening of the stores being dependent on external factors. The court also pointed out that the equipment’s cost could not be charged against any income until the new store was open for business. In Samadi v. Comr.,44 the petitioner began investing in homes with friends and family. The group would buy homes, renovated them, and then sell them – a “fix and flip” strategy. The petitioner became a licensed real estate agent in 2010 and continued that licensing in 2013 and 2014, but earned no commissions from selling real estate in 2013 or 2014. He researched potential investment properties for the group and had access to properties that were for sale. The group never got beyond merely looking at real estate for which auto mileage was claimed for driving to and from the same house, which was the home of the petitioner’s brother and where a “client” lived, and for miles driven to take the client to look at a potential investment property. The IRS disallowed any deductions, taking the position that the petitioner had not yet begun operating a trade or business. The Tax Court agreed. The Tax Court noted that merely having a real estate license is insufficient to create a trade or business of being a real estate agent. The petitioner did not continuously and regularly buy and sell real estate as a real estate agent to clients. The Tax Court also noted that the house flipping business had also not commenced in the years in question. The business was merely in the exploratory or formative stages. The Tax Court noted that carrying on a trade or business requires more than initial research into a potential business opportunity. Deductions are not allowed for startup or pre-opening expenses before business operations begin. The Tax Court noted that startup expenses are held until the time the business begins. At that time, the expenses are either deducted or amortized over 180 months in accordance with I.R.C. §195(b). If the business never starts, the expenses are not deductible.

Observation. In practice, the determination of when an asset is placed in service is highly fact-dependent. In addition, the answer to the question can turn on the type of asset that is involved.

Commercial buildings. As applied to commercial buildings, for example, the IRS tends to use the date on a certificate of occupancy as a factor in determining the placed-in-service date of the building or a portion of the building. But, in Stine, LLC v. United States,45 the court held that the two buildings of a retail operation at issue in the case were placed in service in the year when they were ready and available to store equipment and contained racks, shelving and merchandise. The court viewed it as immaterial that the certificates of occupancy for the buildings did not allow public access until the next year. The placed-in- service date was important in Stine because the taxpayer sought to have the buildings placed in service in 2008 (rather than 2009) to be eligible to deduct Gulf Opportunity Zone bonus depreciation on the buildings.

41 Treas. Reg. §1.167(a)-11(e)(1)(i). 42 See, e.g., Simonson v. United States, 752 F.2d 341 (8th Cir. 1985); Richmond Television Corp. v. United States, 345 F.2d 901 (4th Cir. 1965). 43 803 F.2d 1572 (11th Cir. 1986). 44 T.C. Sum. Op. 2018-27. 45 No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. 2015).

Note. The IRS issued a non-acquiescence in Stine.46 The IRS said that it will continue to litigate the placed- in-service issue on the basis of its position that a retail store isn’t placed in service until it is open for business.

For a building that is completed in sections, depreciation may be claimed on each section as it is completed and placed in service.47 Thus, depreciation can be claimed on each section from the time that section is completed and placed in service.48 Machinery and equipment. As for machinery and equipment, the determination of when the placed-in- service requirement is satisfied is highly fact specific.49 Thus, it is imperative for practitioners to obtain all necessary and relevant facts from clients to support the client’s position taken on the return as the when depreciation deductions commence. IRS audit approach. The IRS has posted to its website a very detailed audit technique guide (ATG) concerning cost segregation studies.50 The guide is useful in terms of the information it provides practitioners concerning its view on what constitutes a properly conducted cost segregation study. Approximately one-half of the ATG provides guidance on casinos, restaurants, retail industries, biotech and pharmaceutical industries, auto dealerships, electrical distribution systems, and stand-alone open-air parking structures. The balance of the ATG provides guidance to practitioners with clients that are considering the use of a cost segregation study as well as those that are under and IRS exam on the matter. The ATG is also useful to practitioners consider performing an in-house cost segregation study. The ATG provides guidance on what the IRS considers to be a quality study.

In the ATG, IRS auditors are advised to closely scrutinize cost segregation studies that are conducted on a contingency fee basis. The IRS believes that such fee structures incentivize the maximization of I.R.C. §1245 costs through “aggressive legal interpretations” or by inappropriate cost or estimation techniques. As a result, firms performing cost segregation studies may be better off billing the work based on the size of the project plus out-of-pocket expenses. Auditors are also advised to conduct in-depth reviews of cost segregation studies to determine the appropriateness of property depreciation classifications and determine if there are any land or non-depreciable land improvements that the study has classified as depreciable property.51

In the ATG, IRS examiners are too closely look at the classification of I.R.C. §1245 and I.R.C. §1250 property. On this distinction, taxpayer records and documentation are critical. IRS will look to see whether a building component designated as I.R.C. §1245 can actually be used for other pieces of equipment. If it can, it will likely be classified as part of the building. The ATG also notes that IRS examiners can use sales tax records of the taxpayer as guidance on the proper allocation between I.R.C. §1245 and §1250 property. Other key points on the I.R.C. §1245/I.R.C. §1250 distinction involve whether the cost segregation study used cost estimates or actual cost records or a residual approach to determine the actual cost of I.R.C. §1245 items. What IRS is looking for is whether the cost of I.R.C. §1245 property has been set too high. Another specific area of examination involves when depreciable and non-depreciable property are acquired in combination for a lump sum. The ATG points out to examiners that the basis for depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property

46 A.O.D. 2017-02 (Apr. 10, 2017). 47 Rev. Rul. 76-142, 1976-1 CB 8. 48 See, e.g., St. Louis Malleable Casting Co. v. Comr., 9 B.T.A. 110 (1927). 49 See, e.g., Rev. Rul. 84-85, 1984-1 CB10; Siskiyou Communications, Inc. v. Comr., T.C. Memo. 1990- 429; F.S.A. 1997-6; Brown v. Comr., T.C. Memo. 2013-275; Brown v. Comr., T.C. Sum. Op. 2009-171. 50 See https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents. 51 This could be a particularly important issue for cost segregation studies involving farm and ranch taxpayers.

82 at the time of the acquisition bears to the value of the entire property at that time.52 Thus, examiners are to look at the fair market values of the properties at the time of acquisition. The fair market value of the land is to be based on its highest and best use as vacant land even if it has improvements on it. Thus, the ATG states that it is not correct for a cost segregation study to estimate land value by subtracting the estimated value of improvements from the lump sum acquisition price. Doing so, according to the IRS, results in an overstatement of the basis of depreciable improvements. The ATG instructs examiners to reconcile total project costs (in terms of cost basis) in the taxpayer’s records with the total project costs in the cost segregation study. Thus, the IRS can be expected to request a copy of the taxpayer’s general ledger data. A key question will be whether costs that should have been in the taxpayer’s building account, for example, are showing up in another account or were expensed. Likewise, the ATG states that examiners should see if costs associated with site preparation, grading and land contouring have been properly (in the IRS view) allocated to land basis rather than being allocated to the overall building cost. Possible penalties. In 2018, the IRS released a CCA taking the position that the preparers of cost segregation studies could be subjected to penalties.53 The CCA involved a set of facts where an engineer/consultant prepared a cost segregation study without having any direct role in preparing tax returns. The engineer/consultant simply provided the completed study to the taxpayer so that the taxpayer could use it in the preparation of the taxpayer’s returns. The cost segregation study divided a 39-year property into component parts, many of which were assigned five-year MACRS lives. On audit, the IRS disagreed with the structural building components being classified as five-year property. Simply correcting the improper classification on the taxpayer’s returns was not enough. The IRS took the position that I.R.C. §6701 could serve as the basis for penalties against the study’s preparer for aiding and abetting the understatement of tax liability. The IRS position was that the engineer/consultant, by preparing the cost segregation study, was aiding or advising in the preparation of the taxpayer’s return. That satisfied I.R.C. §6701(a)(1). Accordingly, the engineer/consultant either knew or had reason to know that the study would be used “in a material matter relative to the IRC.” That satisfied I.R.C. §6701(a)(2). In addition, the IRS argued that the engineer/consultant had actual knowledge that the cost segregation study would result in an “understatement of the tax liability of another person” under I.R.C. §6701(a)(3). This last point is important. If the preparer of a cost segregation study knows that the study inflates depreciation deductions that will result in an understated tax liability, liability is present given that the first two elements of potential liability under I.R.C. §6701 are practically presumed present. The IRS determined that the engineer/consultant was liable for the $1,000 penalty for aiding and abetting the misstatement of individual tax forms. Had a misstated corporate form been involved, the penalty would have been $10,000. However, the IRS took the position that the $1,000 penalty should be imposed multiple times because the cost segregation study contributed to five returns misstating income as a result of the classification of 39-year property as five-year property. Why the IRS didn’t take the position that six $1,000 penalties should be imposed was not clear. Five-year MACRS property results in six-years of depreciation deductions (one-half year’s depreciation in each of year one year six under the one-half year convention). The IRS cited In re Mitchell,54 to support its position that multiple penalties should be imposed.

52 See Treas. Reg. §1.167(a)-5. 53 CCA 201805001(Oct. 26, 2017). 54 977 F.2d 1318 (9th Cir. 1992).

Observation. The CCA indicates that the IRS is looking to establish that a study author has actual knowledge (under the preponderance of the evidence standard) that the study would result in an understatement of tax liability.55 Actual knowledge must be shown. If a cost segregation study is prepared in accordance with the general guidance of Hospital Corporation of America & Subsidiaries,56 penalties should be avoided. But, ambiguities will very likely exist on the distinction between I.R.C. §1245 and I.R.C. §1250 property.

CHARACTER OF LAND SALE GAIN When land is sold, is the gain on sale taxed as capital gain (preferential rate) or as ordinary income? As with most answers to tax questions, the answer is that “it depends.” Most often, when land is sold, particularly by a taxpayer engaged in farming or ranching, when land is sold the resulting gain or loss is capital in nature. But, there can be situations where the gain will be ordinary in nature – particularly when undeveloped land is subdivided or sold off in smaller tracts. Does selling the land in smaller tracts, or subdividing it create ordinary gain rather than capital gain? That raises the question concerning the definition of a “capital asset” and whether a safe harbor applies. What is a capital asset? I.R.C.§1221(a) broadly defines the term “capital asset” as all property held by the taxpayer. Eight exceptions from that broad definition are provided.57 The first exception, I.R.C. §1221(a)(1), states that property that is either inventory or like inventory cannot qualify as a “capital asset.” In particular, I.R.C. §1221(a)(1) says a capital asset does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” Whether a landowner is holding land primarily for sale to customers depends on the facts. As the U.S. Circuit Court of Appeals for the Tenth Circuit put in in the classic case of Mauldin v. Commissioner,58 “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts.”59 Real estate business. For a taxpayer engaged in the real estate trade or business, gains and loss are ordinary in nature. This often requires frequent sales of real estate and similar activity amounting to more than simply an intent to develop the property. For example, in Evans v. Comr., T.C. Memo. 2016-7, the taxpayer’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 2003-2007 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 taxpayer defaulted on the loan and the property was foreclosed on. The taxpayer 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.

55 See, e.g., Mattingly v. United States, 924 F.2d 785 (8th Cir. 1991). 56 109 T.C. 21 (1997), acq. and non-acq. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763. 57 I.R.C. §1221(a)(1)-(8). 58 195 F.2d 714 (10th Cir. 1952). 59 The Fifth Circuit has said essentially the same thing in Suburban Realty Co., v. United States, 615 F.2d 171 (5th Cir. 1980).

Also, the court determined that inadequate properties were involved and that the taxpayer’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. Subdividing real estate. When property is subdivided and then sold, the IRS may assert that the property was being held for sale to customers in the ordinary course of the taxpayer’s trade or business. If that argument holds, the gain will generate ordinary income rather than capital gain. However, I.R.C. §1237 provides (at least) a partial safe harbor that allows a taxpayer “who is not otherwise a dealer”… to dispose of a tract of real property, held for investment purposes, by subdividing it without necessarily being treated as a real estate dealer.” If the provision applies, the taxpayer is not treated as a “dealer” just simply because the property was subdivided in an attempt to sell all or a part of it. What is a “dealer”? It’s not just subdividing land that can cause a taxpayer to be a “dealer” in real estate with gains on sale taxes as ordinary income. “Dealer” classification results if the taxpayer is engaged in the business of selling real estate; holds property for the purpose of selling it and has sold other parcels of land from the property over a period of years; or the gain is realized from a sale in the ordinary operation of the taxpayer’s business. In addition, it’s possible that a real estate dealer may be classified as an investor with respect to some properties sold and capital gains treatment on investment properties. But, as to other tracts, the dealer could be determined to be in the business of selling real estate with the sale proceeds taxed as ordinary income.60 The “safe harbor.” I.R.C. §1237 specifies that gain from the sale or exchange of up to five lots sold from a tract of land can be eligible for capital gain treatment. Sale or exchange of additional lots will result in some ordinary income. To qualify for the safe harbor, both the taxpayer and the property must meet the requirements of I.R.C. §1237 and make an election to have the safe harbor apply.

Note. The safe harbor of I.R.C. §1237 only applies if there is a question of whether capital gain treatment applies. If capital gain treatment undoubtedly applies, I.R.C. §1237 does not apply.61

For the taxpayer to qualify for the election, the taxpayer cannot be a C corporation. Presumably, an LLC taxed as a partnership would qualify. For property to qualify, it must have not previously been held by the taxpayer primarily for sale to customers in the ordinary course of business; in the year of sale, the taxpayer must not hold other real estate for sale as ordinary income property; no substantial improvement that considerably enhances the property value has been made to the property;62 and the taxpayer must have held the property for at least five years.63 If the requirements are satisfied, the taxpayer can elect to have the safe harbor apply by submitting a plat of the subdivision, listing all of the improvements and providing an election statement with the return for the year in which the lots covered by the election were sold. Recent case. In Sugar Land Ranch Development, LLC v. Comr.,64 the taxpayers formed a partnership in 1998 to buy and develop land outside of Houston for the purpose of turning that land into housing developments and commercial developments. The partnership acquired various parcels of land totaling about 950 acres. The land had been a former oil field and so over the years the partnership cleaned up the land, built a levee, and entered into a development contract with the city of Sugar Land, Texas to set up the rules for developing the lots. All of this sounds like the characteristics of a “developer” doesn’t it? By 2008, the partnership had done a lot of work developing the land. But, then the downturn in the real estate market hit and the partnership stopped doing any more work. It wasn’t until 2012 that the partnership sold any significant part of the land. In that year it sold two parcels (about 530 acres) to a homebuilding

60 See, e.g., Murray v. Comr., 370 F.2d 568 (4th Cir. 1967). 61 See, e.g., Gordy v. Comr., 36 T.C. 855 (1961). 62 I.R.C. §1237(b(3); Treas. Reg. §1.1237-1(c)). 63 I.R.C. §1237(a). 64 T.C. Memo. 2018-21,

85 company. The homebuilding company paid a lump sum for each parcel, and also agreed to make future payments relating to the expected development. A flat fee was paid for each plat recorded, and the homebuilding company paid two percent of the final sales price of each house developed on one of the parcels. The partners entered into a “Unanimous Consent” dated December 16, 2008, declaring that the partnership would no longer attempt to develop the land but would instead hold the land until the real estate market recovered enough to sell at a profit. The partnership reported an $11 million gain from the sale of one parcel and a $1.6 million loss on the other parcel. It took the position that the land sold was a “capital asset” and so the gains and losses were capital gains and losses. The IRS disagreed. After all, it pointed out that the partnership acquired the property to develop it and merely delayed doing so because of the economic downturn. Ultimately, the Tax Court agreed that the partnership had successfully changed its operations after 2008 from “developer” to “investor” such that the land it sold in 2012 was a capital asset and the gain was a capital gain. That made a big bottom-line tax difference.

Observation. The partnership in Sugar Land Ranch Development, LLC never actually subdivided the property at issue into separate lots, and the IRS still claimed it was acquired and held for development purposes. While capital gain classification is based on a facts and circumstances test, subdividing land for sale doesn’t necessarily mean that it’s no longer a capital asset. That’s the point of I.R.C. §1237 and the safe harbor. In addition, the facts can cause the reason for holding property to change over time. That, in turn, can change the tax result.

DISTINGUISHING BETWEEN A CAPITAL LEASE AND AN OPERATING LEASE

Overview Economic conditions in much of agriculture have deteriorated in recent years. Prices for many crops have dropped, livestock prices have come down from recent highs, and cash rents and land values have leveled off or fallen. In some instances, agricultural producers leveraged to expand their operations during the good times, only to find that the tougher farm economy has made things financially difficult. In the downturn, legal and tax issues become critically important for many farmers and ranchers. One of those involves the distinction between a capital lease and an operating lease. The Basics A capital lease is a lease in which the only thing that the lessor does is finance the “leased” asset, and all other rights of ownership transfer to the lessee. Conversely, with an operating lease the asset owner (lessor) transfers only the right to use the property to the lessee. Ownership is not transferred as it is with a capital lease, and possession of the property reverts to the lessor at the end of the lease term. As a result, if the transaction is a capital lease, the asset is the lessee’s property and, for accounting purposes, is recorded as such in the lessee’s general ledger as a fixed asset. For tax purposes, the lessee deducts the interest portion of the capital lease payment as an expense, rather than the amount of the entire lease payment (which can be done with an operating lease). Distinguishing Characteristics So, what distinguishes a capital lease from an operating lease and why is the distinction important? There are at least a couple of reasons for properly characterizing capital and operating leases. One reason involves

86 the fact that leases can be kept off a lessee’s financial statements, which could provide a misleading picture of the lessee’s finances. Another reason involves the proper tax characterization of the transaction. With an operating lease, the lessee deducts the lease payment as an operating expense and there is no impact on the lessee’s balance sheet. With a capital lease, however, the lessee recognizes the lease as an asset and the lease payment as a liability on the balance sheet. Also, with a capital lease, the lessee claims an annual amount of depreciation and deducts the interest expense associated with the lease. Based on these distinctions, many businesses prefer to treat lease transactions as operating leases, sometimes when the structure of the transaction indicates that they should not. For a capital lease, the present value of all lease payments is considered to be the asset’s cost which, as noted above, the lessee records as a fixed asset, with an offsetting credit to a capital lease liability account. For accounting purposes, as each lease payment is made, the lessee records a combined reduction in the capital lease liability account and a charge to interest expense. The lessee records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset in its accounting records. The lessor has revenue equal to the present value of the future cash flows from the lease, and records the expenses associated with the lease. For the lessor, a lease receivable is recorded on the lessor’s balance sheet and recognizes the interest income as it is paid. FASB Standards A transaction that is a capital lease has any one of the following features (according to the Financial Accounting Standards Board (FASB)): • Ownership of the asset shifted from the lessee by the end of the lease period; or • The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or • The lease term is at least 75 percent of the estimated economic life of the asset (and the lease cannot be cancelled during that time); or • The value of the minimum lease payments (discounted to present value) required under the lease equals or exceeds 90 percent of the fair value of the asset at the time the lease is entered into. If none of the above factors can be satisfied, the transaction is an operating lease. In that event, the lessee is able to deduct the lease payment as a business expense and the leased asset is not treated as an asset of the lessee. In the typical example, a farmer “trades in” equipment in return for not having to pay any of the operating lease payments or make a large down payment on the lease. If the trade is for a capital lease, with the IRS treating the transaction as a financing arrangement (i.e., a loan), then no gain is triggered on the trade if no cash is received. But there also is no deduction for the lease payments (although interest may be deductible). If the trade constitutes an operating lease, the farmer has gain equal to the amount of “trade-in” value that is credited to the operating lease minus the farmer’s tax cost in the equipment. The gain can be offset (partially or fully) with the lease expense (lease cost amortized for the year of sale). Example: On June 1, 2016, a farmer trades in a used, fully depreciated, tractor worth $120,000 for a new tractor under an operating lease over four years. The farmer will have ordinary income of $120,000 in 2016 and can deduct the lease payments made in 2016 and later years as a business expense. Had the trade occurred late in 2016, it is possible that no lease expense could be claimed in 2016, but that $30,000 could be claimed as a lease expense deduction in each year of 2017- 2020.

TCJA Modification to Like-Kind Exchanges While the above discussion focuses on a trade-in of equipment in return for a lease, it is useful to remember that the recently enacted tax bill modifies the like-kind exchange rules. Under a provision include the “Tax Cut and Jobs Act,” for exchanges completed after December 31, 2017, I.R.C. §1031 is inapplicable to personal property exchanges. Thus, for example, on the trade of an item of farm equipment, the transaction will be treated as a sale with gain recognition on the sale of the item “traded.” The trade-in value is reported as the sales price (Form 4797), with no tax deferral for any I.R.C. §1231 gain or I.R.C. §1245 recapture. The typical result will be that gain will result because most farm equipment has been fully depreciated via expense method or bonus depreciation. The taxpayer’s income tax basis in the new item of farm equipment acquired in the “trade” will be the new item’s purchase price. That amount will then be eligible for a 100 percent deduction (“bonus” depreciation) through 2022. The “bonus” percentage is reduced 20 percentage points annually through 2026. In 2027, a taxpayer would have to report 100 percent of the gain realized on a “trade” of personal property, but could deduct the cost of the item acquired in the “trade” under the expense method depreciation provision of I.R.C. §179 (presently capped at $1 million). The gain on the “trade” is not subject to self-employment tax, and the depreciation deduction on the item acquired in the trade reduces self-employment tax. A further complication, beginning in 2018, is that net operating losses can only offset 80 percent of taxable income. Thus, a taxpayer may want to elect out of bonus depreciation on the newly acquired asset and use just enough expense method depreciation to get taxable income to the desired level. Conclusion Understanding the difference between a capital lease and an operating lease, is helpful to avoiding bad tax and legal results in agricultural transactions. The proper classification very important. It’s a big deal particularly when the agricultural economy turns south.

POST-DEATH SALE OF CROPS AND LIVESTOCK

Overview

When a farmer sells a harvested crop, the tax rules surrounding the reporting of the income from the sale are fairly well understood. But, what happens when a farmer dies during the growing season? The tax issues are more complicated with the tax treatment of the sale tied to the status of the decedent at the time of death – whether the decedent was a farmer or a landlord. If the decedent was a landlord, the type of lease matters.

General Rule For income tax purposes, the basis of property in the hands of the decedent’s heir or the person otherwise acquiring the property from a decedent is the property’s FMV as of the date of the decedent’s death. I.R.C. §1014(a)(1). But, there is an exception to this general rule. Income in respect of decedent (IRD) property does not receive any step-up in basis. I.R.C. §691. IRD is taxable income the taxpayer earned before death that is received after death. IRD is not included on the decedent’s final income tax return because the taxpayer was not eligible to collect the income before death.

In Estate of Peterson v. Comm’r, 667 F.2d 675 (8th Cir. 1981), the Tax Court set forth four requirements for determining whether post-death sales proceeds are IRD.

1. The decedent entered into a legal agreement regarding the subject matter of the sale.

2. The decedent performed the substantive acts required as preconditions to the sale (i.e., the subject matter of the sale was in a deliverable state on the date of the decedent’s death).

3. No economically material contingencies that might have disrupted the sale existed at the time of death.

4. The decedent would have eventually received (actually or constructively) the sale proceeds if he had lived.

The case involved the sale of calves by a decedent’s estate. Two-thirds of the calves were deliverable on the date of the decedent’s death. The other third were too young to be weaned as of the decedent’s death and the decedent’s estate had to feed and raise the calves until they were old enough to be delivered. The court held that the proceeds were not IRD because a significant number of the calves were not in a deliverable state as of the date of the decedent’s death. In addition, the estate’s activities with respect to the calves were substantial and essential. The Tax Court held that all four requirements had to be satisfied for the income to be IRD, and the second requirement was not satisfied.

Farmer or Landlord? Classifying income as IRD depends on the status of the decedent at the time of death. The following two questions are relevant.

1. Was the decedent an operating farmer or a farm landlord at the time of death? If the decedent was a farm landlord, the type of lease matters.

2. If the decedent was a farm landlord, was the decedent a materially participating landlord or a non- materially participating landlord?

For operating farmers (including materially participating farm landlords), unsold livestock, growing crops, and grain inventories are not IRD. Rev. Rul. 58-436, 1958-2 CB 366. See also Estate of Burnett v. Comm’r, 2 TC 897 (1943). The rule is the same if the decedent was a landlord under a material participation lease. These assets are included in the decedent’s gross estate and receive a new basis equal to their FMV as of the decedent’s date of death under IRC §1014. No allocation is made between the decedent’s estate and the decedent’s final income tax return. Treas. Reg. §20.2031-1(b).

From an income tax perspective, all of the growing costs incurred by the farmer before death are deducted on the decedent's income tax return. At the time of death, the FMV of the growing crop established in accordance with a formula is treated as inventory and deducted as sold. The remaining costs incurred after death are also deducted by the decedent's estate. In many cases, it may be possible to achieve close to a double deduction.

If a cash-basis landlord rents out land under a non-material participation lease, the landlord normally includes the rent in income when the crop share is reduced to cash or a cash equivalent, not when the crop share is first delivered to the landlord. In this situation, a portion of the growing crops or crop shares or livestock that are sold post-death are IRD and a portion are post-death ordinary income to the landlord’s estate. That is the result if the crop share is received by the landlord before death but is not reduced to cash until after death. It is also the result if the decedent had the right to receive the crop share, and the share is delivered to the landlord’s estate and then reduced to cash. In essence, for a decedent on the cash method, an allocation is made with the portion of the proceeds allocable to the pre-death period (in both situations) being IRD in accordance with a formula set forth in Rev. Rul. 64-289, 1964-2 CB 173 (1964). That formula splits out the IRD and estate income based on the number of days in the rental period before and after death with the IRD portion being attributable to the days before death. If the decedent dies after the crop share is sold (but before the end of the rental period), the proceeds would have been reported on the decedent’s final

89 return. No prorations would have been required. If the decedent’s crop share is held until death, when the heirs sell the crop share, the proceeds are allocated between IRD and ordinary income of the decedent’s estate under the formula.

IRD results from crop share rents of a non-materially participating landlord that are fed to livestock before the landlord’s death if the animals are also owned on shares. If the decedent utilized the livestock as a separate operation from the lease, the in-kind crop share rents (e.g., hay, grain) are treated as any other asset in the farming operation — included in the decedent’s gross estate and entitled to a date-of-death FMV basis.

Crop share rents fed to livestock after the landlord’s death are treated as a sale at the time of feeding with an offsetting deduction. Rev. Rul. 75-11, 1975-1 CB 27.

Character of Gain Sale of grain. Grain that is raised by a farmer and held for sale or for feeding to livestock is inventory in the hands of the farmer. Upon the subsequent sale of the grain, the proceeds are treated as ordinary income for income tax purposes. I.R.C. §§61(a)(2), 63(b). However, when a farmer dies and the estate sells grain inventory within six months after death, the income from the sale is treated as long-term capital gain if the basis in the crops was determined under the IRC §1014 date-of-death FMV rule. I.R.C. §1223(9). However, ordinary income treatment occurs in the crop was raised on land that is leased to a tenant. See, e.g., Bidart Brothers v. U.S., 262 F.2d 607 (9th Cir. 1959).

If the decedent operated the farming business in a partnership or corporation and the entity is liquidated upon the decedent’s death, the grain that is distributed from the entity may be converted from inventory to a capital asset. See, e.g., Greenspon v. Comm’r, 229 F.2d 947 (8th Cir. 1956). However, to get capital asset status in the hands of a partner or shareholder, the partner or shareholder cannot use the grain as inventory in a trade or business. Baker v. Comm’r, 248 F.2d 893 (5th Cir. 1957). That status is most likely to be achieved, therefore, when the partner or shareholder does not continue in a farming business after the entity’s liquidation.

Conclusion The sale of crops and livestock post-death are governed by specific tax rules. Because death often occurs during a growing period, it’s important to know these unique rules.

TAX ISSUES ON REPOSSESSION OF FARMLAND

Overview Financial distress in the farm sector continues to be a real problem. Low prices in recent years has added to the problem, as have increased debt levels as a result of financed asset purchases during the economic upswing in the ag economy in earlier years. As an example, the level of working capital in the farm sector has fallen sharply since 2012. Working capital for the farm sector as a whole (current assets less current liabilities) is at its lowest level in 10 years, presently at 36 percent of its 2012 peak. In the past year alone, working capital dropped by 18 percent. It has also declined precipitously as a percentage of gross revenue. This means that many farmers have a diminished ability to reinvest in their farming operations. It also means that there is an increased likelihood that a farmer may experience the repossession of farm personal property and real estate. When that happens, the sellers of the assets that repossess have tax consequences to worry about.

Sometimes a Chapter 12 bankruptcy might be filed – and those filings are up in parts of the Midwest and the Great Plains. Other times, farmland might be repossessed. Repossession of Farmland Special exception. A special exception exists under I.R.C. § 1038 that is very favorable to sellers repossessing land under an installment sale – the seller need not recognize gain or loss upon the repossession in either full or partial satisfaction of the debt. It doesn’t matter what method of accounting the seller used in reporting gain or loss from the sale or whether at the time of reacquisition the property has increased or decreased in value since the time of the original sale. However, the rules do not apply if the disposition constitutes a tax-free exchange of the property, and a special problem can be created if related parties are involved. See I.R.C. §453B(f)(2). In addition, for the special rules to apply, the debt must be secured by the real property. When real property is repossessed, whether the repossession is voluntary or involuntary, the amount of gain recognized is the lesser of - (1) the amount of cash and the fair market value of other property received before the reacquisition (but only to the extent such money and other property exceeds the amount of gain reported before the reacquisition); or (2) the amount of gain realized on the original sale (adjusted sales price less adjusted income tax basis) in excess of the gain previously recognized before the reacquisition and the money or other property transferred by the seller in connection with the reacquisition. Handling interest. Amounts of interest received, stated or unstated, are excluded from the computation of gain. Because the provision is applicable only when the seller reacquires the property to satisfy the purchaser's debt, it is generally inapplicable where the seller repurchases the property by paying the buyer an extra sum in addition to cancelling the debt. However, if the parties are related, the seller (according to the statute) must report interest debt that is canceled as ordinary income. I.R.C. §453B(f)(2). But, a question exists as to whether that provision applies in financial distress situations. The rules generally are applicable, however, if the seller reacquires the property when the purchaser has defaulted or when default is imminent even if the seller pays additional amounts. Debt secured by the real property. The provisions on repossession of real property do not apply except where the indebtedness was secured by the real property. Therefore, reconveyance of property by the obligor under a private annuity to the annuitant would appear not to come within the rules. Character of gain. The character of the gain from reacquisition is determined by the character of the gain from the original sale. For an original sale reported on the installment method, the character of the reacquisition gain is determined as though there had been a disposition of the installment obligation. If the sale was reported on the deferred payment method, and there was voluntary repossession of the property, the seller reports the gain as ordinary income. If the debts satisfied were securities issued by a corporation, government or political subdivision, the gain would be capital gain.

Basis issues. Once the seller has reacquired the property, it is important to determine the seller's basis in the reacquired property. The adjusted income tax basis for the property in the hands of the reacquiring seller is the sum of three amounts - (1) the adjusted income tax basis to the seller of the indebtedness, determined as of the date of reacquisition; (2) the taxable gain resulting from reacquisition; and (3) the money and other property (at fair market value) paid by the seller as reacquisition costs.

The holding period of the reacquired property, for purposes of subsequent disposition, includes the holding period during which the seller held the property before the original sale plus the period after reacquisition. However, the holding period does not include the time between the original sale and the date of reacquisition.

Is the personal residence involved? The provisions on reacquisition of property generally apply to residences or the residence part of the transaction. However, the repossession rules do not apply if - (1) an election is in effect for an exclusion on the residence (I.R.C. §121) and; (2) the property is resold within one year after the date of reacquisition. See, e.g., Debough v. Comm’r, 142 T.C. No. 297 (2014), aff’d, 799 F.3d 1210 (8th Cir. 2015). If those conditions are met, the resale is essentially disregarded and the resale is considered to constitute a sale of the property as of the original sale. In general, the resale is treated as having occurred on the date of the original sale. An adjustment is made to the sales price of the old residence and the basis of the new residence. If not resold within one year, gain is recognized under the rules for repossession of real property. An exclusion election is considered to be in effect if an election has been made and not revoked as of the last day for making such an election. The exclusion can, therefore, be made after reacquisition. An election can be made at any time within three years after the due date of the return.

No bad debt deduction is permitted for a worthless or a partially worthless debt secured by a reacquired personal residence, and the income tax basis of any debt not discharged by repossession is zero. Losses are not deductible on sale or repossession of a personal residence. When gain is not deferred or excluded, the repossession of a personal residence is treated under the general rule as a repossession of real property. Adjustment is made to the income tax basis of the reacquired residence.

Special situations. In 1969, the IRS ruled that the special provisions on income tax treatment of reacquisition of property did not apply to reacquisition by the estate of a deceased taxpayer. Rev. Rul. 69- 83, 1969-1 C.B. 202. A decedent's estate was not permitted to succeed to the income treatment that would have been accorded a reacquisition by the decedent. However, the Installment Sales Revision Act of 1980 changed that result. The provision is effective for “acquisitions of real property by the taxpayer” after October 19, 1980. Presumably, that means acquisitions by the estate or beneficiary. Under the 1980 amendments, the estate or beneficiary of a deceased seller is entitled to the same nonrecognition treatment upon the acquisition of real property in partial or full satisfaction of secured purchase money debt as the deceased seller would have been. The income tax basis of the property acquired is the same as if the original seller had reacquired the property except that the basis is increased by the amount of the deduction for federal estate tax which would have been allowable had the repossession been taxable.

The IRS ruled in 1986 that the nonrecognition provision on repossessions of land does not apply to a former shareholder of a corporation who receives an installment obligation from the corporation in a liquidation when that shareholder, upon default by the buyer, subsequently receives the real property used to secure the obligation. Rev. Rul. 86-120, 1986-2 C.B. 145.

Conclusion Tax planning is important for farmers that are in financial distress and for creditors of those farmers. As usual, having good tax counsel at the ready is critical. Tax issues can become complex quickly.

LIFE ESTATE/REMAINDER ARRANGEMENTS AND INCOME TAX BASIS Overview Naming one person to receive the income and/or use of property until death and naming another person to receive ultimate ownership of the property is done for various reasons. One primary reason is to allow one person (or persons) to have the use of property during life and then have someone else own the property after the life estate expires. Life estate/remainder arrangements are also used for estate tax planning purposes. In that instance, the intent of the person creating the life estate/remainder arrangement is to effectively use the estate tax exemptions of both the husband and wife.

The life estate/remainder arrangement also raises some tax issues. One of those issues concerns the income tax basis of the property that is the subject of the arrangement. The cost basis of inherited property is almost always the fair market value of the property as of the testator's date of death. However, what is the income tax basis of property when the various rights to the property are not owned by the same people? Basis Issues The general rule is that property is valued in a decedent’s gross estate at its fair market value as of the date of the decedent’s death. I.R.C. §1014. It is that fair market value that determines the basis of the property in the hands of the recipient of the property. That’s fairly simple to understand when the decedent owns the entire property interest at death. However, that’s not the case with property that is held under a life estate/remainder arrangement. In that situation, the remainder holder does not benefit from the property until the life tenant dies. That complicates the income tax basis computation. Uniform basis. The general idea of uniform basis is that the cost basis of inherited property should equal the value used for estate tax purposes. The new cost basis after death is usually referred to as the “stepped- up” basis, although the new basis can be lower than the original cost. As noted above, it’s tied to the property’s fair market value as of the date of death for purposes of inclusion in the decedent’s estate. The regulations state that the basis of property acquired from a decedent is uniform in the hands of every person having an interest in the property. Treas. Reg. §1.1014-4. As explained in the regulations, under the laws governing transfers from decedents, all ownership interests relate to the death of the decedent, whether the interests are vested or contingent. That means that there is a common acquisition date and a common basis for life tenants and remainder holders. The uniform basis rule is easy to implement after the death of the life tenant, as shown in the following example. ______Example. Boris leaves his entire estate to his son, Rocky, as a remainder holder. However, all income from the estate is payable to his wife, Natasha, until her death. The value of the property is $200,000 at the time of his death. Natasha collects the income from the inherited property for 20 years. When she dies, the appreciated value of the property is $500,000. When Natasha dies, Rocky becomes the sole owner of both the property and the future income. However, because Rocky's ownership of the property is based initially on his father's death, Rocky's basis is $200,000 - the value at the time his father died. ______The result of the example makes sense when you consider that the value of the life estate interest is excluded from Natasha’s estate. Because it was excluded from her estate, there is not basis step-up in Rocky’s hands – the person who receives the right to the income after Natasha dies. If the inherited property is subject to depreciation, the holder of the life interest is allowed to claim the depreciation expense attributable to the entire inherited basis of the depreciable property. Sale of the Life Estate Interest The basis rules change dramatically for the holder of a life estate interest if the rights to the income are sold without the remainder interest being sold as part of the same transaction. If the life interest is sold separately, the seller's basis for tax purposes is $0. I.R.C. 1001(e). The buyer of the life interest can amortize the cost of the purchase over the life expectancy of the seller. ______

Example. Bill leaves a life interest in stock to his neighbor, Dale, and a remainder interest to another neighbor, Bobbi. The value of the stock for estate tax purposes is $5,000 at the time Bill dies. Dale immediately sells his life interest to LuAnn for $100. Dale's cost basis in his life interest is $0. Dale reports the gain of $100 on Schedule D, Capital Gains and Losses, as a long-term capital gain. I.R.C. §1223(10). This transaction has no effect on the uniform basis. The cost basis allocable to Bobbi's remainder interest will continue to increase each year as the life interest's value decreases. Treas Reg. §1-1014. LuAnn is entitled to subtract a portion of the $100 she paid Dale each year against her dividend income. The subtraction is based upon Dale's life expectancy at the time of the sale. Treas. Reg. 1.1014-5(c). Technically, there is no authority directing LuAnn where.to include this subtraction on her return. The conservative approach is to include it in investment expense on Schedule A, Itemized Deductions. An aggressive approach is to treat it in the same way as premiums paid for bonds, which is as a subtraction on Schedule B, Interest and Ordinary Dividends. ______Death of the Remainder Holder If the holder of the remainder interest dies before the holder of the life interest, the uniform basis is not adjusted and the life tenant's basis is still calculated as explained previously. However, the value of the remainder interest is included in the estate of the remainder holder. The regulations, therefore, allow the beneficiary of the remainder holder's estate to adjust the basis for a portion of the value that is included in the estate. This basis adjustment is calculated by subtracting the portion of the uniform basis allocable to the decedent immediately prior to death from the value of the remainder interest included in the estate. ______Example. Marge died in 2006. In her will, she left Bart, her son, a life estate interest in their family home. She left Lisa, her daughter, the remainder interest. In 2010, Lisa died. In Lisa's will, Maggie, her sister, is the sole heir. Bart is still alive. The fair market value of the house in 2006 when Marge died was $100,000. At the time of Lisa's death, her share in the uniform basis was $15,000, based on Bart's life expectancy and the fair market value. The value of the home in 2010 when Lisa died was $200,000. The value of the remainder interest included in Lisa's estate was $30,000. Maggie's basis adjustment in the inherited house is shown below: Value of the house included in Lisa's estate $30,000 Less: Lisa's portion of the uniform basis at her death (15,000) Maggie's basis adjustment in the house $15,000 When the beneficiary to the remainder interest sells the property, the basis is calculated using the beneficiary's current portion of the uniform basis at the time of the sale plus the adjustment.

Conclusion Most people have a pretty good understanding that the income tax basis of property received from a decedent that was included in that decedent’s estate is the fair market value of the property as of the date of the decedent’s death. But, the basis issue becomes more complex when the property at issue is part of a life estate/remainder arrangement. It’s a common estate planning technique, so the issue often arises. Hopefully, today’s post helped sort it out.

BITCOIN FEVER AND THE TAX MAN

Overview Many people have gotten involved in the current Bitcoin “craze.” But, just what is Bitcoin, and what are the tax implications of Bitcoin transactions? The IRS is interested in making sure that all Bitcoin transactions are fully reported and the tax paid. It is also certain that underreporting is occurring. A recent case makes that last point clear.

What is Bitcoin?

Bitcoin, is a digitalized currency (a type of cryptocurrency) that serves as a worldwide payment system. A bitcoin is not a tangible item of property, it’s just a balance that is maintained on a public ledger in the digital cloud along with all Bitcoin transactions as a decentralized digital currency. The Bitcoin network operates as “peer-to-peer” with transactions occurring directly between users. That means that the transactions are anonymous but can be verified by network “nodes” and are recorded in a “blockchain” ledger.

A bitcoin results from a “mining” process and can be exchanged for other currencies as well as products and even services. A Bitcoin balance is maintained by the use of “public” and “private” “keys.” These keys are simply long strings of numbers and letters linked through the mathematical algorithm that was used to create them. The public key (comparable to a bank account number) is the public address to which of this, Bitcoin is popular and other digital currencies (known as “Altcoin”) have developed. Data exists others may send bitcoins. The private key (comparable to an ATM PIN) is meant to be a guarded secret, and is only used to authorize Bitcoin transmissions.

In addition, a bitcoin is not issued by a bank or government and has no intrinsic value by itself. A bitcoin is not legal tender. But, in spite of all showing that, as of early 2015, there were more than 100,000 merchants and vendors that accepted bitcoin as payment. There are millions of users, and the amount presently in circulation is estimated to exceed $7 billion.

Bitcoin can be an effective way of transferring money, but that is different from being a sound investment because of its lack of intrinsic value. It is highly volatile, and since its emergence in 2009, Bitcoin has gone through numerous cycles of spikes and valleys in value. It is much more volatile as gold or the U.S. dollar. These significant swings in value can produce big “winners” when the pendulum swings upward, but big “losers” are also produced when the pendulum swings wildly the other way.

Reporting Cash Transactions

What does the Code say about reporting Bitcoin transactions? If bitcoin is cash, I.R.C. §6050I requires a person engaged in a trade or business to report via Form 8300 a transaction in which more than $10,000 in cash is received. Reporting is also required if more than $10,000 in cash is received during any 12-month

95 period in two or more related transactions. But, is bitcoin cash? Not according to the IRS. In March of 2014, the IRS stated that all virtual currencies, including bitcoins, would be taxed as property rather than currency. IRS Notice 2014-21, 2014-16 I.RB. 938. Thus, gains or losses from bitcoins held as capital will be realized as capital gains or losses, while bitcoins held as inventory will incur ordinary gains or losses. Recent Case In United States v. Coinbase, Inc., No. 17-cv-01431-JSC, 2017 U.S. Dist. LEXIS 196306 (N.D. Cal. Nov. 28, 2017), the IRS served a summons on the defendant, a virtual currency exchange, seeking records of the defendant’s customers for multiple years. The defendant (America’s largest platform for exchanging bitcoin into U.S. dollars) didn’t comply with the request, and the IRS sued to enforce the summons in accordance with I.R.C. §§7402(b) and 7604(a). The IRS later narrowed the scope of the summons so that it applied to fewer of the defendant’s account holders. Nevertheless, the summons still applied to more than 10,000 account holders. The reason for the summons, of course, was because the IRS believes that many taxpayers engaged in Bitcoin transactions are not properly reporting the resulting gain or loss, or are not reporting anything at all. In its petition to enforce the summons, the IRS provided data showing that approximately 84 percent of taxpayers file returns electronically and that capital gain or loss for property transactions (such as Bitcoin) is reported on Form 8949 that is attached to Schedule D (Form 1040). The IRS noted that Form 8949 includes a space where the taxpayer is to report the type of property sold. The IRS also noted that its analysis of its data showed that only 800-900 taxpayers electronically filed a Form 8949 that included a property description that is “likely related to bitcoin” in each of the years at issue – 2013-2015. When the IRS narrowed its summons, it sought information of the defendant’s account holders having accounts “with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013-2015 period.” That excluded the defendant’s customers who only bought and held bitcoin during 2013-2015 or for which the defendant filed Forms 1099-K during that same timeframe. The narrowed summons still applied to 14,355 of the defendant’s account holders and 8.9 million transactions. For those accounts, the IRS wanted registration records for each account, the name, address, tax identification number, date of birth, account opening records, copies of passport or driver’s license, all bitcoin wallet addresses, and all public keys for all accounts. The IRS also wanted the records of “Know- Your-Customer” diligence, as well as agreements or instructions granting a third-party access, control or transaction approval authority. The IRS also sought all information that would identify transactions, their balances and how they were conducted, and any correspondence that the defendant had with the user or any third party with account access. The IRS was also after all periodic statements of account or invoices. The defendant still refused to comply with the summons, narrowed as it was. However, as time went on, the parties started negotiating. But, they couldn’t come to an agreement and the defendant claimed it was too difficult to comply with the summons. The IRS pressed on in court. The issue before the court was the reasonableness of the IRS narrowed summons. The court noted that it was reasonable to the extent it sought information that would aid the IRS in closing the reporting gap between the number of the defendant’s virtual currency users and bitcoin users that reported gains or losses to the IRS during the 2013-2015 time period. In other words, the difference between the defendant’s 5.9 million customers, six billion transactions, and only 800-900 e-filed returns with a property description related to bitcoin. That created, the court noted, an inference that more of the defendant’s customers were trading bitcoin than were reporting gains on their returns. The court determined, based on this data, that the IRS had met the standard of making a minimal showing of meeting the good faith requirement for issuing a summons. In addition, the court rebuffed the defendant’s arguments that the IRS expert was not qualified to testify on the matter. After all, the court pointed out, he was the senior manager on the IRS virtual currency investigation team and personally supervised the analyst who performed the search that generated the data to support the summons. Neither the statute nor applicable caselaw required the IRS to do anything more for the summons request to be granted. In addition, the defendant’s claim that their

96 customers filed paper returns in a greater proportion that the general population was unfounded. In addition, the court held that the narrowing of the summons was not arbitrary, but was based on information gleaned from the defendant during negotiations over the summons request. Importantly, the court held that the IRS summons request involved compliance and not general research into bitcoin data. So, the court approved the narrowed summons request and determined that the IRS had not abused the process or showed a lack of good faith. However, the court determined that certain documents were not required to be provided to the IRS. Those included the defendant’s records of “Know-Your-Customer” diligence; agreements or instructions granting a third-party access, control or transaction approval authority; and correspondence between the defendant and the user or any third party with access to the account with transaction activity. Conclusion Bitcoin seems to be all the rage. The current speculative bubble will burst at some point, but then another bubble is likely to pop back up. Clearly, the IRS is aware of the virtual currency world and is quite interested in making sure that gains (and losses) are reported properly. In addition, it is interested in assessing penalties for not filing appropriate information returns. The penalty is assessed on each instance of a failure to file the appropriate return. If the failure to file the required information return is determined to be an intentional disregard of the requirement, the penalty (for the years at issue in the case) is $250 per return with no maximum total limit. That could be a huge sum for the defendant, and it’s probably what the IRS is actually after. It simply doesn’t have the resources to go after very many individual taxpayers that aren’t reporting Bitcoin gains. But, it will certainly make a show of a few of the more prominent individual taxpayers. In any event, practitioners would be wise to ask clients about any virtual currency transactions, make sure Form 1099-K is filed when required, and maintain good records.

SESSION THREE – 1:00-1:45 p.m.

RECENT CASES AND RULINGS

I. Income Items

A. Self-employment tax

1. Book-Related Payments Are S.E. Taxable. The petitioner is a well-known writer specializing in the macabre and violent crime genre, who has a personal fascination with the inner workings of the Manson family and states that her favorite book is Helter Skelter. She received two types of payments annually from her publisher – a nonrefundable advance and a royalty. No royalty was paid until the total computed amount for the royalty exceeded the nonrefundable advance that had been paid. The petitioner claimed that only the portion of her income related to writing should be subject to self-employment tax as reported on Schedule C, and that the other royalty portion and the portion related to her name brand benefitting a publishing house was properly reported on Schedule E where it was not self-employment taxable. The Tax Court disagreed, noting that none of the petitioner’s contracts allocated advances or royalties between writing and promotion. There were also no noncompete or exclusive option clauses. The Tax Court also noted that the payments were not designated separately for writing and for the petitioner’s brand. The tax preparer also did not have copies of the petitioner’s contracts, simply breaking out the total amount the petitioner received in accordance with the time petitioner spent actually writing. The Tax Court determined that all of the petitioner’s income was associated with the petitioner’s conduct of the petitioner’s trade or business, including the brand activities. Accordingly, all of the petitioner’s income was subject to self-employment tax. The Tax Court also rejected the petitioner’s argument that Rev. Rul. 68-499, 1968-2 C.B. 421 supported her position. That ruling involved two employees that were among five persons owning patents that the employer paid royalties to for licenses to manufacture items. The IRS determined that the royalty paid to the employees was not subject to payroll tax and were not included in their W-2 income. The Tax Court, however, viewed the Rev. Rul. as irrelevant because the issue before the court was self-employment tax where the issue in the Rev. Rul. was payroll tax. The Tax Court noted that self-employment tax was tied to the taxpayer’s conduct of a trade or business whereas payroll tax focused on the definition of wages as payment to an employee for services provided to the employer. As such, all of the petitioner’s brand activities were related to the conduct of the petitioner’s trade or business of writing books. Slaughter v. Comr., T.C. Memo. 2019-65.

B. Exclusion/exemption/deferral from income

1. Some Forgiven Debt Excluded From Income. The petitioner had approximately $355,000 of debt forgiven. The loans on her principal residence could not be excluded under the principal residence debt forgiveness exception (effective through 2017) because the debt was not used to acquire or substantially improve the residence. But, amount she used to pay for a driveway project on a former principal residence did qualify. The IRS also concede that the petitioner was insolvent by $42,852. Consequently, the petitioner qualified under the insolvency provision to exclude the canceled debt from income to the extent of the insolvency. She could also exclude approximately $5,000 attributable to a home equity line of credit. The remaining approximately $307,000 of canceled debt was not excludible from income. The

petitioner could not show that any of it had been used to pay for home improvements. Bui v. Comr., T.C. Memo. 2019-54.

2. Court Construes Illinois Bankruptcy Law Application to IRA. Under Illinois bankruptcy law, "A debtor's interest in or right, whether vested or not, to the assets held in or to receive pensions, annuities, benefits, distributions, refunds of contributions, or other payments under a retirement plan is exempt from judgment, attachment, execution, distress for rent, and seizure for the satisfaction of debts if the plan is intended in good faith to qualify as a retirement plan under applicable provisions of the Internal Revenue Code... or..." (735 ILCS § 5/12-1006(a)) A "retirement plan" includes an individual retirement annuity or individual retirement account. (735 ILCS § 5/12-1006(b)(3)). State law also bars buying property with the intent of converting nonexempt property into exempt property. Under I.R.C. §408(d)(1), amounts distributed from an IRA are included in the payee’s gross income. But, under I.R.C. §408(d)(3), the amount is excluded if the entire amount is later paid into an eligible retirement plan no later than 60 days after the date on which the payee receives the distribution. In this case, the debtor withdrew $50,000 from his IRA on April 16, 2018. He then used $30,000 to buy lottery tickets. He put the remaining $20,000 into another IRA on June 15, 2018. He then filed bankruptcy on October 22, 2018. The bankruptcy trustee claimed that the $20,000 was not exempt because they had been commingled with other funds in the debtor’s checking account and could no longer be determined to be the exact $20,000 withdrawn from the original IRA. The court flatly rejected the trustee’s argument, noting that there is no tracing requirement that requires the originally withdrawn funds to be the same funds rolled over into another qualified account within the 60-day timeframe. The court also noted that the trustee did not allege any fraud with respect to the transfer from the personal account to the new retirement account, nor claim that the debtor bought property with the intent of converting nonexempt property into exempt property. As a result, the $20,000 was exempt. In re Jones, No. 18-31532, 2019 Bankr. LEXIS 1198 (Bankr. S.D. Ill. Apr. 15, 2019).

3. Ministerial Housing Allowance Income Exclusion Constitutional – Trial Court Reversed. The plaintiff, an atheist organization, challenged as unconstitutional the cash allowance provision of I.R.C. §107(2) that excludes from gross income a minister's rental allowance paid to the minister as part of compensation for a home that the minister owns. The trial court determined that I.R.C. §107(2) is facially unconstitutional under the Establishment Clause based on Texas Monthly, Inc. v. Bullock, 489 U.S. 1 (1989) because the exemption provides a benefit to religious persons and no one else, even though the provision is not necessary to alleviate a special burden on religious exercise. The court noted that religion should not affect a person's legal rights or duties or benefits, and that ruling was not hostile against religion. The court noted that if a statute imposed a tax solely against ministers (or granted an exemption to everyone except ministers) without a secular reason for doing so, the law would similarly violate the Constitution. The court also noted that the defendants (U.S. Treasury Department) did not identify any reason why a requirement on ministers to pay taxes on a housing allowance is more burdensome for them than for non-minister taxpayers who must pay taxes on income used for housing expenses. In addition, the court noted that the Congress could rewrite the law to include a housing allowance to cover all taxpayers regardless of faith or lack thereof. On appeal, the court vacated the trial court's decision and remanded the case for dismissal because the plaintiff lacked standing. While the plaintiff claimed that they had standing because they were denied a benefit (a tax exemption for their employer-provided housing allowance) that is conditioned on religious affiliation, the court noted that the argument failed because the plaintiff was not denied the parsonage tax break because they had

never asked for it and were denied. As such, the plaintiff's complaint is simply a general grievance about an allegedly unconstitutional tax provision. Importantly, I.R.C. §107(1) was not implicated and, as such, a church can provide a minister with a parsonage and exclude from the minister's income the rental value of the parsonage provided as part of the minister's compensation. Freedom From Religion Foundation, Inc. v. Lew, 773 F.3d 815 (7th Cir. 2014), vacating and remanding, 983 F. Supp. 2d 1051 (W.D. Wisc. 2013). In order to establish standing, the plaintiff then filed several amended returns that claimed refunds based on the exclusion for a housing allowance from the employee's income. The IRS paid one refund claim, failed to act within the required six months on another amended return, and denied the refund on another amended return and the plaintiff sued challenging the denial of the refund. The IRS later disallowed the refund on another amended return. On the standing issue, the trial court (in an opinion written by the same judge that wrote the initial trial court opinion in 2013) determined (sua sponte) that standing could be established when the IRS fails to act within six months. The trial court also noted that the IRS had explained its rationale for the disallowed refund claim, which indicated that the IRS would take future action on this issue with other taxpayers and provided a basis for standing. On the merits, the court again determined that I.R.C. §107(2) was an unconstitutional violation of the Establishment Clause of the First Amendment as an endorsement of religion that served no secular purpose in violation of Lemon v. Kurtzman, 403 U.S. 602 (1971). The provision, the court noted, inappropriately provided financial assistance to a group of religious employees without any consideration to secular employees that are similarly situated. However, the court did not provide a remedy because the parties did not develop any argument in favor or a refund, a particular injunction or both or otherwise develop an argument regarding what the court should do if it found I.R.C. §107(2) was found unconstitutional. The trial court stayed its opinion pending appeal. On further review, the appellate court reversed. The appellate court noted that while the exclusion of housing provided for the convenience of the employer provision was not made available to ministers of the gospel, the Congress soon provided an exclusion for church-provided ministerial housing as well as the cash allowance provision of I.R.C. §107(2) at issue in this case. The appellate court determined that the provision was simply an additional provision providing tax exemption to employees that having a work-related housing requirement. The appellate court viewed a categorial exemption for ministers as requiring much less government “entanglement” in religion than lumping ministers under the general employer-provided housing exclusion of I.R.C. §119. The appellate court also noted the long history of tax exemption for religious organizations, and deemed this long history of significance and that I.R.C. §§107(1)-(2) continued that history. Gaylor, et al., v. Mnuchin, No. 18-1277 (7th Cir. Mar. 15, 2019), rev’g., Gaylor v. Mnuchin, 16-cv-215-bbc, 2017 U.S. Dist. LEXIS 165957 (W.D. Wisc. Oct. 6, 2017).

Note: After the 7th Circuit’s reversed the district court’s opinion, the plaintiff announced that it would not ask the Supreme Court to hear the case.

4. Settlement Proceeds Excludible if Paid on Account of Physical Injury or Sickness. The petitioner sued his former employer for emotional distress damages he allegedly sustained as a result of being fired. The suit settled, and the employer issued the petitioner Form 1099-MIsc. to report the amount paid. The petitioner did not report the amount, claiming that they were excludible from income under I.R.C. §104(a)(2). The IRS rejected that argument and the Tax Court agreed. The Tax Court noted that the petitioner had to prove that there was a direct causal link between the damages and personal injuries sustained. The Tax Court held that while the petitioner had physical symptoms such as nausea, vomiting and headaches, those symptoms were

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within the definition of nonexcludable emotional distress damages. The Tax Court, however, did not impose an accuracy-related penalty by virtue of the petitioner relying of professional tax advice and because the IRS examining agents did not seek supervisory approval for imposing penalties. Doyle v. Comr., T.C. Memo. 2019-8.

5. Cancelled Debt Is Taxable Income. The petitioner, a financial advisor, joined a new brokerage firm that loaned him $3.6 million as a signing bonus. The loan was evidenced by a promissory note with $40,000 due and payable monthly and would be deducted from the taxpayer's compensation, a common industry practice. However, the petitioner was forced to resign and, according to the terms of the employment agreement, the loan became due and payable. The taxpayer disputed the forced resignation and brought an action against the brokerage firm. FINRA (Financial Industry Regulatory Authority) was asked to resolve the dispute through arbitration. FINRA determined that the loan should be forgiven but did not explain the rationale for their decision. The petitioner claimed that the unpaid portion of the loan proceeds was merely compensation for his book of business and the settlement should be taxed as a capital gain. The Tax Court noted that amounts received for injury or damage to capital assets in excess of basis would be taxable as capital gain, but that amounts received for lost profits are taxable as ordinary income. The Tax Court determined that the petitioner did not meet his burden to establish that the book of business was the reason for the settlement. The Tax Court held that the extinguishment of the taxpayer's debt constituted cancellation of debt income and the full amount was taxable as ordinary income. Connell v. Comr., T.C. Memo. 2018-213.

6. Exchange of Real Property For Financial Instruments Is Not A “Like-Kind” Exchange. The plaintiff exchanged its power plants for an interest in financial instruments, and claimed that the tax on the transaction was deferred under the like- kind exchange rules of I.R.C. §1031. The appellate court, in affirming the Tax Court, determined that the transaction did not involve true leases, but were loans because the benefits and burdens of ownership didn’t transfer between the parties to the exchange. Exelon Corporation v. Comr., No. 17-2964/2965, 2018 U.S. App. LEXIS 28023 (7th Cir. Oct. 3, 2018).

7. No Income Exclusion For Cancelled Debt. The petitioner did not report income from cancelled mortgage debt on Form 1099-C. The IRS included the discharged debt in income and the Tax Court agreed. While there is an exception for reporting discharged debt if it relates to the taxpayer’s principal residence, the petitioner failed to prove that the home to which the cancelled mortgage debt related was his principal residence. The petitioner also could not establish that he was insolvent (another exception to the inclusion rule for discharged debt). Smethers v. Comr., T.C. Memo. 2018-140.

C. Accounting

1. S Corporation is Related Party to ESOP Beneficiaries – No Accrued Wage Deduction. The taxpayer was the founder and owner of an S corporation. During the tax years at issue, 2009-2010, the corporation maintained an employee stock ownership plan (ESOP) for its employees that owned stock in the corporation. During those same two years, the corporation, accrued expenses for wages, vacation pay and other payroll items on behalf of its employees. Some of the accrued expenses were not paid until the following year. The IRS claimed that the ESOP was a “trust” within the definition of I.R.C. §267(c)(1) with the result that the beneficiaries (the ESOP- participating employees) were related persons and the corporation could not accrue wages to be paid to participants in the ESOP. I.R.C. §267(a) bars taxpayers from receiving a tax benefit for a related accrual basis taxpayer for an item that won’t be

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treated as income for the related party until a later year. I.R.C. §267(e) says that, with respect to an S corporation, an S corporation is a related party to a holder of any interest in the corporation whether that interest is held directly or indirectly. The Tax Court held that the ESOP was a trust for purposes of the related party rules and the Tenth Circuit affirmed. Petersen v. Comr., No. 17-9003, 2019 U.S. App. LEXIS 14360 (10th Cir. May 15, 2019), aff’g., 148 T.C. 463 (2017).

D. Miscellaneous

1. Cash Gifts To Pastor Constituted Taxable Income. The petitioner, the pastor of a church and the head of various church related ministries in the U.S. and abroad. The petitioner got behind on his tax filings and IRS audited years 2008 and 2009. While most issues were resolved, the IRS took the position that cash and checks that parishioners put in blue envelopes were taxable income to the petitioner rather than gifts. The amounts the petitioner received in blue envelopes were $258,001 in 2008 and $234,826 in 2009. There was no question that the church was run in a businesslike manner. While the church board served in a mere advisory role, the petitioner did follow church bylaws and never overrode the board on business matters. As for contributions to the church, donated funds were allocated based on an envelope system with white envelopes used for tithes and offerings for the church. The white envelopes also included a line marked “pastoral” which would be given directly to the petitioner. The amounts in white envelopes were tracked and annual giving statements provided for those amounts. The petitioner reported as income the amounts provided in white envelopes that were designated as “pastoral.” Amount in gold envelopes were used for special programs and retreats were included in a donor’s annual giving statement. Amounts in blue envelopes (which were given out when asked for) were treated as pastoral gifts and the amounts given in blue envelopes were not included in the donor’s annual giving statement and the donor did not receive any tax deduction for the gifted amounts. Likewise, the petitioner did not include the amounts given in blue envelopes in income. The IRS took the position that the amounts given by means of the blue envelopes were taxable income to the petitioner. The Tax Court agreed, noting that the petitioner was not retiring or disabled. The court also noted that the petitioner received a non-taxable parsonage allowance of $78,000 and received only $40,000 in white envelope donations. The court also upheld the imposition of a penalty because the petitioner, who self-prepared his returns, made no attempt to determine the proper tax reporting of the donations. Felton v. Comr., T.C. Memo. 2018-168.

2. “Kid” Wages Included in Parent’s Income. The petitioner co-founded a tax-exempt organization and was the sole financial officer. He did not receive a salary from the organization due to the organization’s lack of cash, however, he did hire and pay his adult children $260,000 over a six-year period for work they performed for the organization. However, the petitioner did not issue a Form W-2 or Form 1099, and some of the funds were deposited into an account that the petitioner controlled. The petitioner used the funds in the account to pay his household expenses. The IRS took the position that the funds should be included in the petitioner’s income. The Tax Court agreed on the basis that the petitioner was the party that actually earned the income. Ray v. Comr., T.C. Memo. 2018-160.

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II. Deduction Items

A. Losses

1. Taxpayer Can’t Establish Exchange Basis; Selling Price In Foreclosure Sale Established FMV. The petitioners sold a tract of real estate in a foreclosure sale six years after acquiring it in a like-kind exchange. At that time, the petitioner submitted Form 8824 with the return that showed the basis of the three tracts received in the exchange. At the time of the exchange, the petitioner reported that the basis had been allocated among the properties based on their relative fair market values. The tract in issue was assigned a basis of $618,767. After adjustment for assumed liabilities and those that were satisfied in the exchange, the basis of the tract was represented to be $988,938. The tract was then sold as part of another like-kind exchange and another Form 8824 was filed, coupled with information on debt and the allocation of basis to the replacement properties. A new basis was established for the replacement tract – still the tract in issue. As a result of the foreclosure sale, the IRS challenged the basis of the tract to the extent its basis was tied to the basis of the tract that was sold as part of the initial like-kind exchange (e.g., the carryover portion). The only evidence the petitioner produced to establish basis were the depreciation schedules from the tax return for the year of the first like-kind exchange. The petitioner did not produce a settlement statement or deed. The Tax Court determined that the carryforward basis had not been properly documented and limited the petitioner’s basis in the tract to the cash paid and the debt assumed at the time the tract was acquired. As for the amount of canceled debt, the Tax Court noted that the petitioner owed $10,764 at the time of foreclosure, but that the only bidder for the property bid $7,204. The IRS claimed that there was no willing seller, no appraisal, and, as such, the price paid was not the true fair market value of the property. However, the Tax Court noted that, under Treas. Reg. §1.166-6(b)(2), the bid price is presumed to be the fair market value absent clear and convincing evidence to the contrary. The Tax Court pointed out that the lack of an appraisal meant that there was no clear and convincing evidence of a true fair value to overcome the presumption that the price was the fair value. The IRS then claimed that if the bid price were the fair market value, the remaining note balance was discharge of indebtedness income taxable as ordinary income. However, the Tax Court noted that because the bank filed a proof of claim in the petitioner’s later bankruptcy proceeding the taxpayers later filed, the preponderance of evidence suggested that the balance of the loan survived the foreclosure sale. Consequently, there was not a simultaneous cancellation of indebtedness, triggering ordinary income, at that time. Thus, the petitioner had a net capital loss on the foreclosure sales which was less than the petitioner originally reported, but more than the IRS claimed. Breland v. Commissioner, TC Memo 2019-59.

2. Taxpayer Materially Participated in Money Lending Business. The petitioner sold his trucking business and started a money lending business with an office in Chicago that capitalized on the network of contacts in the Chicago construction industry he had made while running his trucking business. The money lending business office was staffed with an accountant and a secretary. The petitioner made the determinations regarding making loans and the handling of loans that were in default. While the petitioner didn’t have another job that occupied his time, he only spent about 40 percent of the year in Chicago. He lived in Florida the balance of the time. He only worked about 200 days annually, from the Chicago office and from his Florida home. While in Chicago, he lived either in his home or his apartment. He did maintain a regular office schedule when in Chicago, working in the office at least 460 hours per year. When in Florida, he called the office daily and communicated via phone, fax and email. He averaged about two hours per day on lending business while in Florida. The

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money lending business lost money and the petitioner deducted the losses and also claimed a carryover net operating loss (NOL) to 2011 and 2012. The IRS denied the losses on the basis that the petitioner was not materially participating in the business and that the losses were passive losses that could only offset passive income. The IRS asserted deficiencies and penalties for 2009-2012 totaling over $600,000. The court noted that the petitioner cleared the 100-hour hurdle of Treas. Reg. §1.469-5T(a), and that the facts revealed that the participated in the business on a basis that was regular, continuous and substantial. Thus, the losses were fully deductible. He also participated more than 500 hours, but the court did not mention the application the 500-hour test in the Treasury Regulations. The court, however, ruled that the petitioner was potentially liable for penalties attributable to an underpayment of tax from other adjustments unrelated to the issue of material participation. Barbara v. Comr., T.C. Memo. 2019-50.

3. No Basis Increase in S Corporate Stock. The taxpayer was a shareholder in an S corporation that bought a condominium complex in a bankruptcy sale. To fund its operations, the S corporation accepted funds from numerous related entities. Ultimately, lenders foreclosed on the complex, triggering a large loss which flowed through to the taxpayer. The taxpayer deducted the loss, claiming that the amounts that the related entities advanced created stock basis (debt basis) allowing the deduction. The IRS disallowed the deduction and he Tax Court agreed. The appellate court affirmed on the grounds that the advances were not back-to-back loans, either in form or in substance. In addition, the related entities were not “incorporated pocketbooks” of the taxpayer. There was no economic outlay by the taxpayer that would constitute basis. There was no contemporaneous documentation supporting the notion that the loans between the taxpayer and the related entities were back-to-back loans (e.g., amounts loaned to a shareholder who then loans the funds to the taxpayer), and an accountant’s year-end reclassification of the transfers was not persuasive. While the taxpayer owned many of the related entities, they acted as business entities that both disbursed and distributed funds for the S corporation’s business expenses. The appellate court noted the lack of caselaw supporting the notion that a group of non-wholly owned entities that both receive and disburse funds can be an incorporated pocketbook. To generate basis, the appellate court noted, a loan must run directly between an S corporation and the shareholder. Meruelo v. Comr., No. 18-11909, 2019 U.S. App. LEXIS 13305 (11th Cir. May 6, 2019).

4. No Supreme Court Review of Hobby Loss Case. The petitioner operated a real estate group that her father had founded. In 1998, the petitioner started a quarter horse breeding, training, showing and selling business. In operating the horse business, the petitioner bought the best mares; acquired stallions to breed; bred the mares; produced foals; and culled some foals and trained the balance. The petitioner did not have a formal business plan other than a five-page handwritten “business plan” that included a single-page income and expense projection that her CPA prepared in response to an IRS audit. Sometime after 2005, the petitioner moved some of the horses from Virginia to Texas and contracted with businesses there. The petitioner traveled to Texas once annually for approximately a week each time. The petitioner maintained a separate mailing address for the horse activity and also a separate checking account that she used to pay most of the horse-related expenses. She also maintained a separate brokerage account for the horse activity that she used to pay show fees, camping fees and other horse-related expenses. The petitioner reviewed the horse activity invoices and receipts once monthly. For tax years 2004-2010, the horse activity lost money, with approximately $2 million of losses incurred in just two of those years. The IRS, on audit, denied the loss deductions from the horse activity on the basis that the activity was not conducted with a profit intent. The petitioner was

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not entitled to the presumption of profit intent because the activity did not produce income in excess of deductions for any two of seven consecutive years. The Tax Court examined the nine factors for determining a profit intent under Treas. Reg. §1.183-2(b) and concluded that the petitioner did not have a profit intent. The appellate court affirmed and the U.S. Supreme Court declined to hear the case. Hylton v. Comr., T.C. Memo. 2016-234, aff’d., No. 17-1776, 2018 U.S. App. LEXIS 35001 (4th Cir. 2018), cert. den., No. 18-789, 2019 U.S. LEXIS 966 (U.S. Sup. Ct. Feb. 19, 2019).

5. NOLs Can’t Be Carried Back. The plaintiff sought a refund attributable to his 2004 return based on a net operating loss (NOL) carryback. The IRS denied the carryback and the plaintiff paid the deficiency and sought a refund in court. The trial court disallowed the refund and the plaintiff appealed. The appellate court affirmed, determining that the application for refund based on an NOL carryback was not a claim refund in accordance with I.R.C. §6411(a). In addition, the appellate court noted that the plaintiff did not timely file a 2004 refund claim under I.R.C. §7422(a). In addition, the appellate court held that the plaintiff’s claim fell outside of I.R.C. §1346(a)(1) which meant that the trial court did not have jurisdiction over the claim. The plaintiff also sought a refund for 2005 based on an NOL carryback. However, the appellate court held that the plaintiff failed to meet his burden of proof of entitlement to a refund for 2005. The appellate court also held that the government was not equitably estopped from denying his refund requests. Silipigno v. United States, No. 17-2452, 2019 U.S. App. LEXIS 3191 (2nd Cir. Jan. 30, 2019), affn’g., 2017 U.S. Dist. LEXIS 107608 (N.D.N.Y. Jul. 12, 2017).

6. No Reversal of NOL Carryback to Wipe Out Tax Obligation. The plaintiffs, a married couple, signed and filed their 2013 federal income tax returns in which their paid preparer had overstated a net operating loss (NOL) of almost $4.7 million from the plaintiffs’ business, an investment firm. The loss was carried back and offset income in 2011 and 2012, generating refunds for those years. The plaintiffs also signed their 2014 return for which the preparer had elected to waive an NOL of approximately $12 million in accordance with I.R.C. §172(b)(3). The preparer believed that no tax liabilities remained in the years to which the loss would be carried under the default rules (2015 and later years) and attached the election to the return which meant that the loss could only be carried forward. The preparer did not notify the plaintiffs of the waiver because she believed that the 2013 NOL would cover any past tax liability. Upon audit of the 2011-2014 returns, the IRS disallowed the overstated NOL and assessed a deficiency of $685,000 for 2012. The plaintiffs attempted to change the 2014 election waiver so as to carryback the 2014 loss to offset the tax liability, but the IRS rejected the ability to do so claiming that the plaintiffs had waived the right. The Tax Court agreed, and the plaintiffs appealed. The appellate court affirmed on the basis that I.R.C.§172(b)(3) states the election, one made, is irrevocable. In addition, the appellate court noted that when the plaintiffs signed the return at issue, they affirmed that they had examined it, further confirming that the election was irrevocable. The appellate court noted that there is nothing in the statute that required either the court or the IRS to judge the plaintiffs’ subjective intent in making the election. Bea v. Commissioner, No. 18-10511, 2019 U.S. App. LEXIS 3153 (11th Cir. Jan. 31, 2019).

7. Capitalization Required For Interest and Real Property Taxes Associated with Crops Having More Than Two-Year Pre-productive 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

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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 pre-productive 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” generally includes growing crops and plants where the pre-productive period of the crop or plant exceeds two years. Because almond trees have a pre-productive period exceeding two years in accordance with IRS Notice 2000-45, 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., No-17-71810, 2018 U.S. App. LEXIS 34267 (9th Cir. Dec. 5, 2018), aff’g., T.C. Memo. 2016-224.

8. Real Estate Professional Test Not Satisfied. A decedent’s estate attempted to reclassify the decedent’s rental activities as active under the real estate professional test of I.R.C. §469(c)(7). However, the Tax Court determined that the estate could not satisfy the 750-hour test. The decedent was involved in other non-rental activities and did not maintain a contemporaneous diary of the time spent of real estate activities. The testimony of the decedent’s daughter was deemed not credible. In addition, the decedent had not elected to group the various rental activities as a single activity which meant that the decedent needed to meet the real estate professional test with respect to each rental activity. The Tax Court did not impose an accuracy-related penalty because the IRS did not prove that the penalty had been approved by an IRS supervisor. Estate of Ramirez v. Comr., T.C. Memo. 2018-196.

9. Real Estate Professional Test Not Met. The petitioners, a married couple, managed rental properties that they owned which lost money. The IRS denied the loss deduction on the basis that the petitioners were passive investors. The petitioners produced computerized logs that showed the hours the wife spent on the rental properties. However, the Tax Court, agreeing with the IRS position, noted that the wife’s activities were mere investment activities that didn’t count toward the 750-hour test of I.R.C. §469(c)(7)(B). In addition, the logs included entries for time spent attending seminars because the petitioners could not show how the seminars pertained to managing the rental properties. In addition, the logs were inconsistent and included excessive hours for time spent by management companies that were hired or services that repairmen or gardeners performed. There were no other supporting documents to substantiate the wife’s hours spent on the rental properties. Antonyshyn, et ux. V. Comr., T.C. Memo. 2018-169.

10. Real Estate Professional Test Satisfied - Passive Loss Deduction Allowed. The petitioners, a married couple, managed rental properties that generated a significant loss. The IRS denied the loss as a passive loss and assessed approximately $9,000 in penalties. The IRS determined that the petitioners had failed to satisfy the real estate professional test of I.R.C. §469(c)(7). The wife was involved in the daily management of the rental properties. She cleaned the common areas, collected coins from washing machines, performed repairs, communicated with tenants, deposited rent, maintained

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insurance policies, bought materials for the properties, paid bills, and kept the books and records for tax purposes. The wife also hired contractors to perform tasks that she couldn’t complete herself, and would spend considerable time researching and contacting contractors. She also inspected rental units, prepared them for rental, advertised vacant units, screened potential tenants, showed the units and processed rental applications. Her records showed that she logged 844.75 hours managing the rental properties in 2014 and, when investor hours and driving time were included, she logged 1, 136 .25 hours. The log was constructed from the wife’s calendar for the first half of 2014 and from her phone for the second half of 2014. She also supplied receipts and invoices to substantiate the hours logged. While the IRS conceded that the wife satisfied one of the tests of I.R.C. §469(c)(7) – she did not perform personal services in any other trade or business and, thus, spent more than half of her time on the rental activity, the IRS claimed that she failed to satisfy the 750-hour test on the basis that her logs were not contemporaneous and “contained inaccuracies.” The Tax Court disagreed with the IRS, noting the wife’s credible, honest and forthright testimony, and detailed spreadsheets of management activities. While the court cautioned that the records weren’t contemporaneous, her credible testimony and time logs were a “reasonable means” of proof that convinced the court that the real estate professional test was satisfied. Birdsong v. Comr., T.C. Memo. 2018-148.

11. No Deductible Losses Associated With Horse-Leasing Activity. The petitioners, a married couple had almost $500,000 of cancelled debt income in 2001. In early 2002, they got involved in a “mare lease and breeding activity” via the husband’s friend. The venture was designed to produce net operating losses that could be carried back to prior tax years to offset income in the carryback years, and also possibly generate gains that would be capital in nature and taxed at a favorable tax rate. Participants in this type of venture have been involved in prior Tax Court litigation. The petitioners were advised that they needed to put in at least 100 hours annually into the activity which they did via entities that they created. Ultimately, the activity generated $1.3 million in losses. The IRS denied the losses and the Tax Court agreed with the IRS. The Tax Court determined that the petitioners did not spend at least 500 hours annually in the leasing/breeding activity and did not handle any of the daily operations or management. Instead, the Tax Court determined that the petitioners’ involvement in the activity was passive. They also did not engage in the activity with a profit intent – their involvement was primarily recreational and they used the activity to offset their large income from other sources. Householder v. Comr., T.C. Memo. 2018-136.

12. Horse Activity Had Profit Motive, But Was Passive. The petitioners, a married couple, worked for a technology company in the San Francisco Bay. During the years in issue, 2010-2014, the husband’s salary ranged from $1.4 million to $10.5 million. He also was an Executive Vice President of Hewlett-Packard Co. In 1999, the petitioners bought a 410-acre tract in Utah for $2,000,000. They later acquired additional land, bringing their total land holdings to over 500 acres. After refurbishing the property, the hired a full-time manager to operate the ranch. However, the plaintiffs never showed a profit from their “ranching” activity. They showed losses ranging from slightly under $200,000 to nearly $750,000 every year. The petitioners deducted the losses, which the IRS disallowed. The Tax Court applied the nine-factor test of Treas. Reg. 1.183-2(b) and determined that the petitioners did have a profit motive. However, the employment of a ranch manager indicated to the Tax Court that the petitioners might be engaged in a passive activity subject to the passive loss rules of I.R.C. §469. Of the seven tests contained in Treas. Reg. §1.469-5T(a) to determine whether the petitioners were materially participating in the activity on a basis that was regular, continuous and substantial, the Tax Court determined that only two were relevant – the 500-hour test and the facts and circumstances test. The petitioners prepared logs

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showing that they devoted more than 500 hours to the activity during the years in issue, but the logs were prepared after-the-fact in preparation for trial. The Tax Court determined, that “a very significant portion” of the hours the petitioners spent on the activity were as investors rather than as material participants. In addition, the presence of the paid manager destroyed the hours the petitioners devoted to management activities. Accordingly, the Tax Court determined that the 500-hour test had not been satisfied. The presence of the manager also meant that the petitioners could not satisfy the facts and circumstances test. Thus, the petitioners were entitled to claim the deductions for the losses from the ranching activity, but the deductions were suspended until years in which they showed a profit from the activity. In those, years, the deductions would be limited to the profit from the activity. If they never showed a profit, the losses could be deducted upon sale of the activity. Robison v. Comr., T.C. Memo. 2018-88.

13. Expert Witness Report Properly Excluded in Hobby Loss Case. At issue is whether the petitioners conduct a horse-related activity with a profit intent. Presently before the court is an IRS motion to exclude from evidence the taxpayer’s expert witness report concerning the value of the horses on the basis that the report failed to satisfy Federal Rule of Evidence 702 or Tax Court Rule 143(g)(1) by not detailing facts or data on which the expert relied. The report also didn’t identify principles and methods the expert employed, or show that the expert employed the methods in a reliable way. A thumb-drive allegedly containing the data had been given to the IRS, but it was not contained in the expert’s report. The thumb-drive was given to the IRS only days before trial and contained massive amounts of data on many horses, not just the ones at issue in the litigation. The Tax Court granted the motion of the IRS to exclude the petitioner’s expert witness report. Skolnick, et al. v. Comr., T.C. Memo. 2019-64.

14. Horse Activity Triggers Hobby Loss Rule. The petitioners bought a horse in 2011 and participated in horse shows in 2014 and 2015. The horse was top-ten in its class nationally, and the petitioners hoped to be able to sell the horse for more than they purchased it for. However, the lost more than $100,000 and sold the horse for what they paid for it. The petitioner’s deducted the $100,000 loss and the IRS rejected the deduction and assessed a penalty exceeding $6,000. The Tax Court agreed with the IRS that the hobby loss rules under I.R.C. §183 were not satisfied in that the petitioners had not engaged in the activity with a profit intent. The Tax Court noted that the petitioners had not conducted the activity in a businesslike manner. They had no written business plan and didn’t keep accurate books and records. They also made no changes in how they conducted the activity to reduce expenses or generate additional income, and did not attempt to educate themselves on how to conduct the activity. They also did not rely on the activity as a major source of their income, and never came close to making a profit. Sapoznik v. Comr., T.C. Memo. 2019-77.

15. Decades of Losses Result in Application of Hobby Loss Rules. The petitioners, a married couple, sustained losses in their horse breeding/racing activity for almost 30 years without ever showing a profit. The husband was a computer programmer and his wife a retired paralegal and business executive. The wife had been a life-long horse enthusiast. They operated the activity via a partnership as a “virtual farm.” The IRS denied the loss deductions from the activity for particular years. The Tax Court agreed with the IRS on the basis that the petitioners couldn’t satisfy the requirements of the regulations under I.R.C. §183. The Tax Court noted that the evidence that it was clear that the petitioners didn’t operate the activity in a businesslike manner. The petitioners didn’t breed, race or sell any of their horses during the years at issue. While they had

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separate bank accounts and some records, the records were incomplete or inaccurate. While the petitioners had written business plans, the plans projected net losses and remained essentially unchanged from the original plans 30 years earlier. The petitioner long string of unbroken losses were used to offset non-farm income, and the petitioners derived substantial personal pleasure from the activity. They left the “grueling aspects” of the activity to others that they paid, and there was no evidence that they sought expert advice concerning how to make a profit at the activity. Instead, they sought only general advice. Donoghue, et ux. v. Comr., T.C. Memo. 2019-71.

16. Grouping Not Allowed – Passive Loss Rules Apply. The petitioner, an aviation buff, purchased an airplane that he made available for rent, used for personal purposes, and used in his other business. The petitioner used the losses from operating the airplane against income from the petitioner’s other businesses including a law practice focusing on business and aviation law. The petitioner also operated a telephone skills training business for which he conducted training seminars. The petitioner spent more than 2,000 hours in the telephone training business for the tax year in issue. He also actively participated in the rental of five properties that he owned during the tax year. The petitioner did not spend sufficient hours in the airplane business to avoid the application of the passive loss rules. Consequently, the petitioner sought to group the airplane and telephone training businesses together such that the losses from the airplane business could offset the income from the petitioner’s other activities. The Tax Court determined that the airplane activity and the telephone activity could not be grouped because they did not constitute and appropriate economic unit. The appellate court affirmed. Williams v. Comr., No.15-71505, 2019 U.S. App. LEXIS 15930 (9th Cir. May 29, 2019), aff’g., T.C. Memo. 2014-158.

B. Charitable deduction

1. Multi-Million Charitable Deduction Denied For Failure to Substantiate Basis. The petitioner donated an LLC interest that was subject to a prior estate-for-years to a university. The petitioner included an Appraisal Summary (Form 8283) with the return, but the Appraisal Summary failed to disclose the basis in the donated LLC interest which had been purchased for $2,950,000. The petitioner made the donation 17 months after the interest had been purchased and claimed a charitable deduction associated with the donated interest of $33,019,000. Two years after receiving the LLC interest, the done sold it for $1,940,000 to another LLC that the donor indirectly owned. On appeal, the appellate court affirmed because the petitioner failed to comply with the requirements of Treas. Reg. §1.170A-13 for the lack of disclose of the income tax basis of the LLC interest in a manner to allow IRS to determine the allowable deduction. The appellate court also upheld a 40 percent accuracy-related penalty under I.R.C. §6662 for gross valuation misstatement because the state value of the donated property was more than 400 percent of the property’s actual value. The appellate court also held that the petitioner did not show a good faith investigation under I.R.C. §6664(c)(3) to qualify for the reasonable cause exception to the penalty. The petitioner did not show any attempt had been made to investigate the value of the interest in addition to the appraisal. RERI Holdings I, LLC v. Commissioner, 149 T.C. No. 1 (July 3, 2017), aff’d., sub. nom., Blau v. Comr., No. 17-1266, 2019 U.S. App. LEXIS 15510 (D.C. Cir. May 24, 2019).

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2. No Charitable Deduction For Lack of Substantiation. The petitioner claimed a charitable deduction in 2010 for over $107,000 attributable to land improvements to property that a charity owned. The improvements occurred over several years and were made by the petitioner’s LLC. The petitioner did not claim any charitable deductions in the years that the improvements were made. The IRS denied the deduction and the Tax Court agreed. The petitioner conceded that the did not own the improvements, and the Tax Court noted that the petitioner could not claim the deduction in 2010 because the improvements were paid for in years preceding 2010. In addition, the Tax Court noted that even if the improvements had been paid for in 2010, the amounts that the LLC paid for were not directly connected with or solely attributable to the rendering of services by the LLC to the charity as Treas. Reg. §1.170A-1(g) requires. In addition, the Tax Court determined that the petitioner did not satisfy the substantiation requirements and did not include Form 8283 and did not have an appraisal of the improvements made as required when a charitable deduction exceeding $5,000 is claimed. Presley v. Comr., T.C. Memo. 2018-171.

3. No Charitable Deduction for Donated Conservation Easement. The petitioner claimed a $10.4 million charitable deduction related to the donation of a permanent conservation easement on a golf course. The IRS denied the deduction on the basis that the easement was not exclusively for conservation purposes because it didn’t protect a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem as required by I.R.C. §170(h)(4)(A)(ii). The IRS also asserted that the donation did not preserve open space for the scenic enjoyment of the general public or in accordance with a governmental conservation policy for the public’s benefit under I.R.C. §170(h)(4)(A)(iii). The Tax Court agreed with the IRS and denied the deduction. The Tax Court determined that the “natural habitat” requirement was not met – there was only one rare, endangered or threatened species with a habitat of only 7.5 percent of the easement area. In addition, the Tax Court noted that part of the golf course was designed to drain into this habitat area which would introduce chemicals into it. Thus, the easement’s preservation of open space was not for public enjoyment nor in accordance with a governmental policy of conservation. Champions Retreat Golf Founders, LLC v. Comr., T.C. Memo. 2018-146.

4. Subordination Requirement Strictly Applied - Conservation Easement Perpetuity Requirement Not Satisfied; Penalties Tacked-On. The petitioner acquired a building in 2001 for $58.5 million. In 2004, the petitioner transferred a façade easement on the building via deed to a qualified charity (a preservation council) to preserve the exterior building perimeter. The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building – the petitioner and any subsequent owner couldn’t demolish or alter the protected elements without the charity’s permission. The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from its mortgagee banks. However, the easement deed provided that in the event the façade easement was extinguished through a judicial proceeding, the mortgagee banks will have claims before that of the donee charity to any proceeds received from the condemnation proceedings until the mortgage is satisfied. By the time of the easement donation, the value of the building had increased to $257 million, of which $33.4 million was attributable to the easement. The petitioner claimed a $33.4 million charitable contribution deduction for the tax year of the easement contribution. The IRS disallowed the deduction, claiming that the easement deed failed to satisfy the perpetuity requirements of I.R.C. §170 and Treas. Reg. §1.170A-14(g)(6)(ii) because it provided the mortgagees with prior claims to the extinguishment proceeds in preference to the donee. Specifically, the lender had agreed to subordinate the debt to the charity's claims, but the easement deed said that

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the lender would have priority access to any insurance proceeds on the property if the donor had insurance on the property. The easement deed also said that the lender would have priority to any condemnation proceeds. The petitioner claimed that the First Circuit's decision in Kaufman v. Comr., 687 F.3d 21 (1st Cir. 2012) applied. In that case, the First Circuit rejected the view that a subordination must remove any preferential treatment of the lender in all situations, creating an exception for unusual situations that could possibly occur at some point in the future. The First Circuit determined that the Tax Court's reading of what is necessary to grant a perpetual easement would eliminate easement donations because an easement represented only a partial interest in property. In addition, the First Circuit reasoned that a broad reading was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due which could result in the loss of the property without the charity receiving a pro rata portion of the property value. However, in the present case, the Tax Court rejected the view of the First Circuit, noting that its decision would be appealable to the Seventh Circuit which meant that the Tax Court was not bound by the First Circuit's decision. The Tax Court reasoned that because the lender had superior rights in certain situations, the mortgages did not meet the subordination requirement of Treas. Reg. §1.170A-14(g). Thus, the donated easement did not meet the perpetuity requirement of I.R.C. §170(h)(5). The Tax court also pointed out that other Circuits had agreed with the Tax Court's interpretation of the subordination rule since Kaufman was decided. The Tax Court also noted a difference concerning what must be done to subordinate an existing liability at the time of the donation (such as a mortgage) as opposed to a possible future liability that was not yet in existence. The Tax Court also noted that the Treasury Regulations specifically mentioned mortgages in the list of requirements necessary to satisfy the perpetuity requirement, but made no mention of a need to have taxing agencies to agree to give up rights to a priority interest that might arise in the future for delinquent taxes when the taxes were not delinquent. The IRS assessed a gross valuation misstatement penalty in 2008 and additional accuracy-related and negligence penalties in 2014. The petitioner contested the penalties, but the Tax Court, in a later proceeding, determined that there is no requirement that IRS determine the penalties at the same time or by the same IRS agent. The only requirement, the Tax Court held, was that each penalty, at the time of initial determination, was approved in writing by a supervisor before being communicated to the petitioner. That requirement was satisfied. Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017). Later proceeding on the penalty issue at 152 T.C. No. 4 (2019).

5. Disallowance of State Conservation Easement Tax Credit Timely. A corporation donated a conservation easement and transferred part of the resulting state tax credit to the defendants, a married couple. The defendants claimed the credit on their 2006 state income tax return. In 2007, the transferor corporation also claimed the credit and the state disallowed the credit in its entirety. The defendant claimed that the state’s notice of disallowance in March of 2011 was untimely because their 2006 filing triggered a four-year statute of limitations for the state to disallow a claimed credit. The state claimed that the corporation’s filing of a 2007 return tolled the statute and that the disallowance was timely. The trial court determined that the disallowance was timely, but the appellate court reversed, finding that the first filed return claiming the credit (2006) tolled the statute and, as a result, the state’s disallowance was not timely. On appeal, the State Supreme Court reversed. The Supreme Court determined that Col. Rev. Stat. §39-22-522(7)(i) and CO Dept. of Rev. Reg. §201-2:39-22-522(3)(g)(i) tolled the statute of limitations when the donor filed a return in October of 2007 claiming the credit. Because that occurred with the filing of the corporation’s 2011 return, the state’s disallowance within four years of the filing date of the 2007 return was timely. The Supreme Court reversed the decision of the court of appeals and remanded the

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case. Colorado v. Medved, No. 17SC33, 2019 Colo. LEXIS 25 (Colo. Sup. Ct. Jan. 14, 2019).

6. No Charitable Deduction for Conservation Easement. The petitioner acquired a tract and later conveyed conservation easements on small portions of the property to a qualified land trust, intending to claim a tax deduction for the value of the contribution pursuant to I.R.C. §170. Each easement set forth a defined area that was to be perpetually restricted from being developed and also specified where “building areas” could occur, all with the state purpose of protecting natural habitats of fish and wildlife and preserve open space to provide scenic enjoyment to the public. However, the easement conveyed in 2006 did not delineate the location of the building areas, and the 2005 easement conveyed allowed the petitioner (with the consent of the qualified land trust), to shift the building areas to another location within the conservation area. The 2005 easement also allowed the petitioner to construct in the conservation area such things as barns, riding stables, scenic overlooks, boat storage buildings, etc. The petitioner claimed charitable deductions for the easements which the IRS denied on the basis that the easements weren’t qualified real property interests under I.R.C. §170(h)(1)(A) and were not used exclusively for conservation purposes under I.R.C. §170(h)(1)(C), and that the fair market value of the easements were overstated. A majority of the full Tax Court agreed with the IRS because the easements did not restrict development on a specific, identifiable piece of property and it appeared that the petitioner could take back the conserved areas and use it for residential development that were not subject to the conservation easements. As such, the Tax Court determined that the easements did not constitute “a restriction (granted in perpetuity) on the use which may be made of the real property…”. The Tax Court, however, pointed out that the easement conveyed in 2007 did cover a specific, identifiable tract and was granted in perpetuity and was made exclusively for conservation purposes and did not reserve in the petitioner any right to construct structures appurtenant to residential development. In addition, the Tax Court noted that the language in the 2007 easement providing for amendments did not disturb the qualified nature of the easement because any amendment had to be “not inconsistent with the conservation purposes of the donation.” The Tax Court, in denying the charitable deduction for the 2005 and 2006 easements followed its decision in Belk v. Comr., 140 T.C. 1 (2013) which the Fourth Circuit affirmed. Belk v. Comr., 774 F.3d 221 (4th Cir. 2014). The Tax Court also determined that the acceptable boundary modification provisions present in the easements involved in Bosque Canyon Ranch II, L.P. v. Comr., 867 F.3d 547 (5th Cir. 2017) were distinguishable from those in Belk because they didn’t allow any the exterior boundaries of the easements or the acreages to change. Pine Mountain Preserve, LLLP v. Comr., 151 T.C. No. 14 (2018).

7. No Charitable Contribution For Donated Conservation Easement. The petitioner claimed a $1,798,000 charitable deduction for the contribution of a permanent conservation easement. The IRS disallowed the deduction in its entirety on the basis that the plaintiff stood to benefit from the contribution by virtue of owning land that adjoined the property subject to the easement and that the plaintiff had plans to create a master-planned community. The court agreed with the IRS, noting that “the plaintiff would benefit from the increased value to the lots from the park as an amenity.” Wendell Falls Development, L.L.C. v. Comr., T.C. Memo. 2018-45, motion for reconsideration denied, T.C. Memo. 2018-193.

8. Charitable Deductions Denied For Failure To Satisfy Numerous Requirements. The petitioner was an optometrist that he operated via an S corporation. The petitioner was also the pastor and president of a non-profit religious corporation. The petitioner donated a tractor/mower to the religious corporation but

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failed to substantiate the donation by not getting an appraisal and include Form 8283 with the tax return. The petitioner also failed to substantiate the donation of his residence to the religious corporation. The petitioner also could not deduct land improvement costs (creation of ponds to provide irrigation source for the petitioner’s blueberry farm) that the petitioner’s single-member LLC farming operation would operate on land leased from the religious corporation. The improvements were made and costs paid before the donation. The petitioner also didn’t execute a contemporaneous acknowledgment that was dated. Presley, et ux. v. Comr., T.C. Memo. 2018-171.

9. No Charitable Contribution Deduction For Donated Easement by Lessee. A nonprofit corporation owned two buildings that were listed on the National Register of Historic Places. The petitioner was the long-term lessee of the buildings. The parties jointly transferred a façade easement on the buildings in 2009 to a qualified organization and the petitioner claimed a charitable deduction of approximately $4.5 million for the donation. The IRS denied the deduction because the petitioner did not own a fee interest in the buildings, and assessed an accuracy-related penalty. Without fee ownership, the IRS claimed that the perpetuity requirement of I.R.C. §§170(h)(2)(C) and (h)(5)(A) could not be satisfied. The petitioner, however, claimed that fee ownership was not expressly required and that the contribution was similar to a façade easement granted by tenants in common. The petitioner also claimed, in the alternative, that it was the equitable owner of the buildings for tax purposes and equitable ownership was sufficient to claim the deduction. The Tax Court agreed with the IRS that the petitioner could not claim a deduction. The court determined that the only thing the petitioner gave up were the contractual rights it held under the lease rather than a qualified property interest. Thus, the petitioner could not grant a perpetual restriction on the use of the buildings as required for the deduction. A personal property right (e.g., contractual rights under the lease) is not a qualified property interest under I.R.C. §170(h)(2)(C). The court also rejected the petitioner’s argument that it was the equitable owner of the buildings for property tax purposes because, even if the petitioner were, it was only for a finite period rather than for an indefinite period. The building owner, however, could grant a perpetual easement that could give rise to a charitable deduction. Harbor Lofts Associates v. Comr., 151 T.C. No. 3 (2018). 10. Conservation Easement Donation Not Perpetual – Charitable Deduction Denied. The petitioner owned a tract of land subject to a use restriction requiring it to only be used for recreational facilities open space for 30 years. At the time of the petitioner’s ownership, the property was a golf course with a clubhouse. The petitioner wanted to sell the property, but before doing so wanted to remove the use restriction. A local buyer expressed interest, but also wanted to block any removal of the use restriction. The sale went through after the buyer agree to allow the removal of the use restriction. However, before the sale closed, the petitioner conveyed a conservation easement of the property to a land trust. The terms of the easement stated that the property was to remain open for public use for outdoor recreation and that fees for such use could be charged. Upon extinguishment of the easement, the land trust would be entitled to a portion of the sale proceeds equal to the greater of the fair market value of the easement at the time of the donation or a share of the proceeds after expenses of sale and an amount attributable to improvements constructed on the property. The Tax Court denied any charitable deduction for the easement based on its findings that the easement did not protect the conservation purpose under I.R.C. §170(h)(4)(A) and didn’t satisfy the perpetuity requirement of I.R.C. §170(h)(5)(A) because the easement deed’s extinguishment provision did not comply with Treas. Reg. §1.170A-14(g)(6). As such, the easement donation was not “exclusively for conservation purposes as required by I.R.C. §170(h)(1)(C). The Tax Court held that the easement value was $100,000 rather than the $15.2 million that the petitioner claimed. The Tax Court also

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upheld the gross valuation misstatement penalty that the IRS had imposed. On appeal, the appellate court affirmed that the petitioner was not entitled to any charitable deduction and upheld the penalty. The appellate court held that when determining whether the public access requirement for a recreation easement is fulfilled, the focus is to be on the terms of the deed and not the actual use of the land post-donation. The appellate court determined that the terms of the easement satisfied the public-access requirement of Treas. Reg. §1.170A-14(d)(5)(iv)(C). However, the appellate court concluded that the contribution was not exclusively for conservation purposes because the requirements of Treas. Reg. §1.170A-14(g)(6)(ii) were not satisfied because the deed allowed the value of improvements to be subtracted from the proceeds before the donee took its share, and that Priv. Ltr. Rul. 200836014 no longer represented the current position of the IRS and could not be used to alter the plain meaning of the regulation which mandates that the done receive at least the proportionate value of the “proceeds.” The appellate court also agreed with the Tax Court that the gross valuation misstatement penalty applied to the difference between the amount the petitioner deducted on its return ($15 million) and the $100,000 deduction allowed by the Tax Court. PBBM-Rose Hill, Ltd., v. Comr., No. 17-60276, 2018 U.S. App. LEXIS 22523 (5th Cir. Aug. 14, 2018).

C. Marijuana

1. No Deductions for Medical Marijuana Dispensary. The petitioner, a corporation, operated a medical marijuana dispensary in a state where medical marijuana is legal. As a result of doing business, the corporation incurred business expenses and attempted to deduct expenses that were allegedly not associated with medical marijuana. To do so, the corporation allocated expenses between its trafficking and non-trafficking activities. An S corporation was organized to handle the daily operations for the petitioner, including the payment of employee wages and salaries. The petitioner deducted business expenses that it claimed were not associated with trafficking activities, and also adjusted its cost of goods sold (COGS) to include indirect expenses in accordance with I.R.C. §263A. The IRS determined that both the petitioner’s and the S corporation’s sole trade or business was trafficking in a controlled substance. Thus, I.R.C. §280E barred any business expense deductions. The IRS also determined that the shareholders of the S corporation had underreported their flowthrough income from the S corporation, and that the petitioner could not claim COGS in an amount greater than what the IRS had previously allowed. The IRS applied an accuracy-related penalty to the petitioner. The Tax Court agreed, holding that both the petitioner and the S corporation were barred by I.R.C. §280E from deducting business expenses; that the petitioner could not claim COGS greater than what IRS had allowed; and that the S corporation shareholders underreported their flowthrough income. The Tax Court also upheld the accuracy-related penalty. Alternative Health Care Advocates, et al. v. Comr., 151 T.C. No. 13 (2018).

2. No Business Deductions For Pot Shop. The petitioner is a dispensary of marijuana, a controlled substance under federal law. The petitioner claimed business-related expense deductions on the basis that its business was comprised of four separate enterprises: 1) marijuana and marijuana product sales; 2) sales of products without marijuana; 3) therapeutic services; and 4) brand development. The IRS denied the deductions and the Tax Court agreed with the IRS. The Tax Court determined that the dispensary had a single trade or business – trafficking in a controlled substance. Thus, deductions associated with the non-marijuana aspect of the business were not deductible. The petitioner was also required to adjust for cost of goods sold as a reseller rather than as a producer. Patients Mutual Assistance Collective Corporation v. Comr., 151 T.C. No. 11 (2018).

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3. I.R.C. §280E Doesn’t Discriminate Against S Corporations. The petitioners were owners of an S corporation engaged in the illegal drug business of growing and selling an illegal drug, marijuana. The IRS treated the petitioner’s wage income as an S corporation expense subject to I.R.C. 280E which caused the income to be taxed twice – once as wages and again as S corporation income. The petitioners claimed that this double taxation resulted in the disallowed officer wages attributable to the illegal drug activity to be included in the S corporation earnings which then flowed through to the shareholders without an offsetting deduction. In essence, the petitioners were allocated wages and the balance of S corporate earnings, which they reported on their return. However, the IRS disallowed the wage expense which resulted in passthrough income of the entire amount of S corporate earnings, with the petitioners still having the wage income to report. The petitioners claimed that this tax treatment violated the purpose and intent of Subchapter S. The Tax Court disagreed, noting that the petitioners were free to operate as any business entity, chose the S corporate form, and were responsible for the tax consequences of their choice. Loughman v. Comr., T.C. Memo. 2018-85.

4. No Business-Related Deductions For Pot Shop. The petitioner claimed various business-related deductions associated with operating its business that dealt in marijuana and the IRS denied the deduction in accordance with I.R.C. §280E. I.R.C. §280E disallows deductions for expenses paid or incurred in the carrying on of any trade or business (including employee salaries) involving a federal controlled substance such as marijuana, a Schedule I controlled substance under federal law. The Tax Court agreed with the IRS position, and also upheld the imposition of a 20 percent penalty on the petitioner for underpayment of tax liability. Alterman v. Comr., T.C. Memo. 2018-83.

D. Recordkeeping

1. No Deductions Due to Poor Records. The petitioners, a married couple claimed various business expenses on Schedule C. They self-prepared their return for 2014, the year in issue. Their Schedule C reported no gross receipts and total expenses of $28,173. They also claimed unreimbursed employee expenses of $23,931 on Schedule A. The IRS denied the Schedule C and Schedule A deductions and also took the position that the petitioners failed to report $25,622 of IRA distributions (and the associated penalty for early withdrawal). The IRS also determined that the petitioners failed to report $123,168 of cancelled debt income. The IRS also imposed a penalty for underpayment of tax associated with the substantial understatement of tax. The Tax Court determined that the wife failed to provide sufficient evidence that she was engaged in a business with a profit motive. The Tax Court also concluded that the wife failed to substantiate any of the business expenses associated with the wife’s business and provided no means for the court to estimate those expenses under the Cohan rule. In addition, the court noted that the Cohan rule has no application to I.R.C. §274(d) expenses (e.g., travel and entertainment expenses, gifts and listed property which are subject to strict substantiation requirements). While the petitioners claimed that they should not be subject to the 10 percent penalty for early withdrawal from their IRA because the withdrawn funds were used to pay for their daughter’s college tuition, The Tax Court, however, upheld the penalty because the petitioners failed to establish that the withdrawn funds were actually used to pay the daughter’s tuition. The Tax Court also upheld the imposition of a 20 percent penalty for substantial understatement of tax. On that issue, the Tax Court noted that the petitioners were college-educated and used a tax software (TurboTax), that software was not the same as relying on professional tax advice. Dasent v. Commissioner, T.C. Memo. 2018-202.

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2. Uber Driver Failed to Substantiate Expenses. The petitioner claimed deductions for uniforms, shirts, shoes, mileage and other expenses associated with his job as a driver for a ride sharing company. While the IRS allowed some deductions, many were disallowed due to lack of substantiation and the lack of supporting records. Hagos v. Comr., T.C. Memo. 2018-166.

3. Expenses Denied For Lack of Substantiation. The petitioner’s job required him to move and operate oil fracking equipment away from his home residence. He deducted the associated travel costs and the IRS disallowed the deductions. The Tax Court agreed with the IRS because the petitioner’s tax home had shifted due to the indefinite work position. The petitioner also owned multiple businesses for which deductions were claimed. The Tax Court also upheld the denial of the business-related deductions due to lack of documentation. Auto-related expenses were also denied due to a lack of a log or diary and the necessary detail for vehicle expense substantiation. Also disallowed was the petitioner’s expense method depreciation deduction for tools on the petitioner’s 2012 return because they were purchased and placed in service in 2011. The Tax Court also denied other expenses due to a lack of documentation or failure to show a business relationship to the expense including a deduction for contract labor because the petitioners could not show how much the worker was paid. Baca v. Comr., T.C. Memo. 2019-78.

4. Failure to Maintain Records Dooms Taxpayer. The petitioners, millionaires, had two rental properties. They ultimately abandoned both properties, but before abandoning the properties the wife spent a great deal of time cleaning and refurbishing one of the properties. The wife stayed at the property while working on it. On audit the IRS claimed that the wife used the property for personal purposes for more than 14 days. Accordingly, the IRS denied the associated rental losses in accordance with I.R.C. §280A. While the petitioners convinced the Tax Court that the time spent at the property was for work on the property rather than for personal purposes, the petitioners failed to establish real estate professional status under I.R.C. §469(c)(7) due to a lack of contemporaneous logs. In addition, the Tax Court sustained the IRS in holding that the petitioners had unreported income based on the bank deposits method. In some instances, it was clear that bank account funds came directly from one account and were promptly deposited in another account, but lack of records prevented the petitioners from establishing the source of other funds in bank accounts. Rose v. Comr., T.C. Memo. 2019-73.

E. Miscellaneous

1. No Deduction For Law School LL.M. Program Tuition. The petitioner attended law school in Spain and subsequently practiced international law in Spain for several years. The petitioner then moved to New York City and enrolled in an LL.M. program, incurring $27,435 in tuition expense. After graduation, the petitioner took a visiting attorney position in the U.S. practicing international law. The LL.M. qualified the petitioner to sit for the NY Bar exam, which he passed and became admitted to practice in NY. The petitioner continued working for the same law firm. The petitioner deduction the LL.M. tuition expense and the IRS denied the deduction. The Tax Court agreed with the IRS because the LL.M. degree allowed the petitioner to take the NY Bar exam and qualify for admission to practice in NY – a new trade or business. In addition, the petitioner did not need the LL.M. degree for his visiting attorney position. Thus, the deduction was properly denied in accordance with Treas. Reg. §1.162-5(b)(3)(i). Note – the deduction for unreimbursed education expenses of employees is presently

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suspended through 2025. Enrique Fernando Dancausa Valle v. Comr., T.C. Sum. Op. 2018-51.

2. No Deductions Because Business Had Yet To Start. The petitioner was starting a boat rental business and incurred repair costs associated with a boat that he intended to rent out. The IRS denied the deductions on the basis that the business had not yet begun. The Tax Court agreed with the IRS on the basis that the boat was not yet seaworthy and, as a result, the petitioner was not yet actively engaged in the boat rental business. The Tax Court also determined that the petitioner was not eligible for a net loss carryover due to the petitioner’s lack of documentation. The Tax Court held the petitioner liable for approximately $20,000 in deficiencies and over $7,000 in penalties for failure to file or make tax payments for two years. De Sylva v. Comr., T.C. Memo. 2018-165.

3. Cost of Seismic Surveys Are G&G Expenditures. The taxpayer was engaged in offshore oil and gas drilling and development activities within the U.S. Via wholly- owned subsidiaries, the taxpayer owned a working interest in and operated two fields, which were discovered in Year 1 and Year 2. The joint owners of both fields sanctioned development in late Year 5, including drilling development wells. In Year 6, the taxpayer approved net funding for the acquisition of a seismic survey of the two fields. The taxpayer used the data generated by the seismic survey to optimize placement of development wells in the two fields. Stage 1 development drilling occurred in both fields, resulting in development wells that first produced oil in Year 8. Through the first quarter of Year 9, The taxpayer had drilled exploratory wells and development or production wells in the development areas of both fields. Stage 2 development drilling began later and included additional wells. The first oil produced from Stage 2 drilling was expected in Year 10. The taxpayer deducted the costs of the seismic survey related to one of the two fields as intangible drilling costs on its Year 7 return. The IRS, however, determined that these costs should be treated as geological and geophysical (G&G) expenditures. In support its claim that the survey was an intangible drilling cost, the taxpayer presented an authorization for expenditure for the seismic survey that stated, among other things, that the purpose of the survey was to provide better imaging than the seismic data previously obtained in Years 3 and Year 4. The IRS disagreed, noting that the legislative history of I.R.C. §167(h)(3) (which requires the amortization of G&G expenses) includes costs incurred for the purpose of obtaining and accumulating data that will serve as the basis for the acquisition and retention of mineral properties by taxpayers exploring for minerals. Survey costs, the IRS concluded, are capital in nature. They were not incurred to prepare for the drilling of a specific well, but were used to determine where to drill. C.C.A. 201835004 (May 10, 2018).

4. Simply Concluding A Partnership Interest Is Worthless Is Not Enough For a Bad Debt Deduction. The petitioners deducted losses associated with their partnership interests on a 2008 amended return. The losses were associated with partnership losses from real estate development. However, the partnerships remained in business and the petitioners did not sell or abandon their interests during the years in issue (2008-2011). Instead, the petitioners subjectively concluded that their interests were worthless as of the end of 2008. The IRS denied the losses and the Tax Court agreed. The Tax Court noted that the petitioners could claim an ordinary loss deduction relating to their partnership investments if the investment is worthless (and sale or exchange treatment does not apply). However, the Tax Court determined that a loss relating to a worthless interest must be evidenced by a closed and completed transaction that is fixed by an identifiable event or events that occurred during the tax year in issue. Simply a decline in the assets’ value is insufficient to justify a loss deduction. The Tax

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Court noted that the filing of bankruptcy, liquidation, insolvency or market events and conditions can sufficiently establish a closed and completed transaction to justify a loss deduction associated with a worthless interest in a partnership. Due to the remaining value in the partnerships in 2008 as a result of its underlying properties, the petitioners’ investments were not worthless. Forlizzo v. Comr., T.C. Memo. 2018-137.

III. Administrative/Procedural

A. Change in substantive law

1. IRS Can’t Change Code Via Administrative Notice. The petitioner received a Form W-2 reporting a difficulty of care payment under I.R.C. §131(c). However, such payments are excluded from income as a type of qualified foster care payment if made under a state’s foster care program. In Tech. Adv. Memo. 2010-007, the IRS took the position that the payment of a difficulty care payment to the parent of a disabled child to the parent was not excludible because the “ordinary meaning” of foster care excluded care by a biological payment. But, in Notice 2014-7, the IRS treated the payment as nontaxable to the recipient. The petitioner did not include the payment in income, but did include the amount as earned income in computing the earned income credit under I.R.C. §32 and in computing the refundable child tax credit under I.R.C. §24. The IRS position was that since the amount was not taxable under Notice 2014- 7, the amount did not count as earned income for computing the credits. I.R.C. §32(c)(2)(A)(i) states that earned income includes wages, salaries, tips and other employee compensation that has been included in gross income for the tax year. The petitioner claimed that nothing in I.R.C. §131 allowed the IRS to treat the payment as not includible in gross income. The court agreed, with the result that the petitioner could exclude the difficulty of care payment and obtain credits on that (untaxed) earned income. Feigh v. Comr., 152 T.C. No. 15 (2019).

B. IRS/court “guidance”

1. IRS Explains Farm Income Averaging/QBID Relationship. Under a farm income averaging election (I.R.C. §1301), a farm taxpayer income tax liability is the sum of the I.R.C. §1 tax computed on taxable income reduced by “elected farm income” (EFI) plus the increase in tax imposed by I.R.C. §1 that would result if taxable income for the three prior years were increased by an amount equal to one-third of the EFI. The IRS has stated that "[i]n figuring the amount [of the]... Qualified Business Income Deduction, income, gains, losses, and deductions from farming or fishing should be taken into account, but only to the extent that deduction is attributable to your farming or fishing business and included in elected farm income on line 2a of Schedule J (Form 1040)." This appears to be saying that if an income averaging election is made, the taxpayer must use EFI to calculate the QBID. In other words, once the farm income averaging election is made, the taxpayer must use EFI to calculate the QBID. This appears to be consistent with I.R.C. §199A(c)(3)(A)(ii). Elected Farm Income May Be Used To Figure Qualified Business Income Deduction, IRS Website, Apr.19, 2019.

Note: The IRS subsequently removed the “guidance” from their website and replaced it with a comment stating that, “In figuring the amount to enter on Form 1040, line 9, Qualified Business Income Deduction, income, gains, losses, and deductions from farming or fishing should be taken into account, but only to the extent that deduction is attributable to your farming or fishing business and included in elected farm income on line 2a of Schedule J (Form 1040

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2. Obamacare’s Individual Mandate is a Tax For Bankruptcy Purposes. I.R.C. §5000A establishes the “individual mandate penalty” (repealed effective for months beginning after 12/31/18) that specifies that if a taxpayer or an individual for whom the taxpayer is liable isn't covered under minimum essential coverage for health insurance for one or more months, then, unless an exemption applies, the taxpayer is liable for the individual shared responsibility payment on his return. The Bankruptcy Code, in accordance with 11 U.S.C. §1328(a), allows a debt to be discharged unless it is listed as a priority claim in 11 U.S.C. §507(a). Priority taxes cannot be discharged, but a penalty amount is dischargeable. In this case, the debtors (a married couple) filed a proof of claim that included a $2,085 mandate assessment which the debtors claimed was dischargeable as a penalty. The IRS disagreed, citing National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012) in which the U.S. Supreme Court concluded that the assessment was a tax for constitutional purposes and cited the Bankruptcy Code in making its determination. The court also found that refusing to purchase health insurance and instead paying an assessment didn't constitute an "unlawful act," which was a strong indication that the individual mandate was not a penalty. In addition, the legislative history implied that the individual mandate was a tax since Congress referred multiple times to how it would raise revenue, the court said. Thus, the assessment was a non-dischargeable tax and was entitled to priority under 11 U.S.C. §507(a)(8) and the court denied the debtors’ objection to the IRS claim. In re Cousins, No. 18-10739, 2019 Bankr. LEXIS 1156 (Bankr. E.D. La. Apr. 10, 2019).

3. IRS Says 2 Percent S Corporation Shareholder Can Claim Self-Employed Health Insurance Deduction. I.R.C. §1372 says that, for purposes of applying the provisions of the I.R.C. that relate to employee fringe benefits, an S corporation is treated as a partnership. Likewise, any 2 percent (as defined in I.R.C. §318 as owning more than two percent of the corporate stock) S corporation shareholder is treated as a partner in the partnership in accordance with I.R.C. §1372. An S corporation can deduct the cost of accident and health insurance premiums that the S corporation pays for or furnishes on behalf (i.e., reimburses) of its 2 percent shareholders. The two percent shareholders must include the amounts in gross income in accordance with Notice 2008-1, 2008-2 IRB 251 (i.e., the S corporation reports the amounts as wages on the shareholder’s W-2) provided that the shareholder meets the requirements of I.R.C. §162(l) and the S corporation establishes the plan providing medical care coverage. Under the facts of the CCA, a taxpayer owned 100 percent of an S corporation which employed the taxpayer’s family member. The family member is a two-percent shareholder under the attribution rules of I.R.C. §318. The S corporation provides a group health plan for all employees, and the amounts paid by the S corporation under the plan are included in the family members gross income. Provided the requirements of I.R.C. §162(l) are satisfied, the IRS determined that the family member could claim a deduction for the amounts the S corporation paid. Thus, the family member could convert what might be a nondeductible expense (because of either the 10 percent floor for medical expenses or because the family member takes the standard deduction) into an above-the-line deduction. C.C.A. 2019012001 (Dec. 21, 2018).

4. No More “Black Hole” For Refund Claims. The taxpayer’s 2012 federal income tax return was due on April 15, 2013. By April 15, 2013, the taxpayer had already made income tax payments for 2012 totaling $112,000. On April 15, 2013, the taxpayer was granted a six-month extension for filing the return. The taxpayer failed to file her return by the extended due date and on June 19, 2015, the IRS issued a notice of deficiency asserting that she owed $1,666,463 in 2012 income tax and $572,756.90 in penalties. The taxpayer filed her 2012 return on August 29, 2015 reporting an income tax liability of $79,559. The parties stipulated that amount was correct. The return also reported

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an overpayment of $32,441. The taxpayer then filed a Tax Court petition seeking a redetermination of the 2012 tax deficiency and a refund for the overpayment. The issue before the court was whether the Tax Court had jurisdiction to order a refund of the overpayment, and the Tax Court determined that it did not based on I.R.C. §6512(b)(3). That Code section, the Tax Court reasoned, only entitled the taxpayer to a two-year lookback period for any refund based on its language which reads, “…where the date of the mailing of the notice of deficiency is during the third year after the due date (with extension) for filing the return of tax and no return was filed before such date, the applicable period under subsections (a) and (b)(2) or section 6511 shall be three years.” Thus, because no return had originally been filed and the IRS had issued a notice of deficiency before the return was filed, the taxpayer couldn’t claim a refund by filing a return after the issuance of the notice. The notice was issued in June of 2015 for the 2012 return that had an original due date of April 15, 2013 and an extended due date of October 15, 2013. Thus, according to the Tax Court, the notice was after the standard two-year statute for refund claims. On appeal, the appellate court reversed. The appellate court noted that I.R.C. §6511(b)(2)(A) provides for a look-back period of three years plus the period for any extensions. Thus, the taxpayer had retained the right to pursue the refund even though the IRS issued the notice of deficiency more than 2 years after the original due date, but before the date two years after the extended due date. Borenstein v. Comr., No. 17-3900, 2019 U.S. App. LEXIS 9650 (2d Cir. Apr. 2, 2019), rev’g., 149 T.C. 263 (2017).

5. IRS Provides Guidance on Home Office Deduction. The IRS has provided guidance on how the $10,000 limitation on the deduction of state and local taxes (SALT) under the Tax Cuts and Jobs Act (TCJA) and I.R.C. §280A work in conjunction with each other. For a taxpayer with SALT deductions at or exceeding $10,000, or who chooses to take the standard deduction, none of the SALT relating to the taxpayer’s business use of the home are treated as expenses under I.R.C. §280A(b). However, expenses relating to the taxpayer’s exclusive use of a portion of the taxpayer’s personal residence for business purposes remain deductible under I.R.C. §280A(b) or (c) or under another exception to the general rule of disallowance in I.R.C. §280A. The same rationale applies to other deductions that are subject to various limitations or disallowances, including home mortgage interest and casualty losses. For instance, interest on a mortgage balance exceeding the acquisition debt limitations becomes an I.R.C. §280A(c) limited expense when claiming a home office deduction. IRS Program Manager Technical Advice 2019-001 (Dec. 7, 2018).

6. REIT Revenue From Oil/Gas Investment Is Rent From Real Property. The taxpayer is a real estate investment trust (REIT) that primarily invests in U.S. energy infrastructure assets and intended to acquire an offshore oil and gas platform, storage tank facilities and pipelines (all of which are real property under I.R.C. §856). The platform includes equipment to manage the extraction and conditioning of oil and gas. The REIT will enter into a multi-year lease that provides the platform lessee with the exclusive right to use the platform and the equipment. The fair market value (FMV) of any personal property, including the equipment, leased to the platform lessee will be less than 15 percent of the total FMV of the real and personal property leased to the platform lessee. The platform lessee will be solely responsible for operating, maintaining and repairing the platform, equipment and any other property associated with the platform. The taxpayer will not perform any activities, and no services will be furnished, in connection with the lease of the platform or equipment. The IRS concluded that the platform rent, storage fees, and pipeline fees to be received will qualify as rents from real property under I.R.C. §856(d) for purposes of the I.R.C. §856(c)(2) 95 percent test and the I.R.C. §856(c)(3) 75 percent test. Priv. Ltr. Rul. 201907001 (Feb. 15, 2019).

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7. “Roberts Tax” Is a Non-Dischargeable Priority Claim in Bankruptcy. The debtor filed Chapter 13 bankruptcy. The IRS filed a proof of priority claim for $5,100.10, later amending the claim to $5,795.10 with $695 of that amount being an excise tax under I.R.C. §5000A as a result of the debtor’s failure to maintain government mandated health insurance under Obamacare. The debtor object to the $695 amount being a priority claim that could not be discharged, and the bankruptcy court agreed, finding that the “Roberts Tax” under Obamacare was not a priority claim, but rather a dischargeable penalty in a Chapter 13 case. On appeal, the appellate court reversed. The appellate court noted that the creditor bore the burden to establish that the Roberts Tax was a priority claim and noted that it was the purpose and substance of the statute creating the tax that controlled whether the tax was a tax or a penalty. The appellate court noted that a tax is a pecuniary burden levied for the purpose of supporting government while a monetary penalty is a punishment for an unlawful act or omission. On this point, the appellate court noted that Chief Justice Roberts, in National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012), upheld the constitutionality of Obamacare on the basis that the “shared responsibility payment” was a tax paid via a federal income tax return and had no application to persons who did not pay federal income tax. The appellate court noted that the amount was collected by the IRS and produced revenue for the government. It also did not punish an individual for any unlawful activity and, the appellate court noted, the IRS has no criminal enforcement authority if a taxpayer failed to pay the amount. United States v. Chesteen, No. 18-2077, 2019 U.S. Dist. LEXIS 29346 (E.D. La. Feb. 25, 2019).

8. IRS Can Charge For PTINs Because They Are A Service That Aids Tax Compliance and Administration. 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 identification. The regulations at issue, however, required preparers to obtain (at a fee paid to the Treasury) a PTIN as the identifying number. Preparers without a PTIN could no longer prepare returns for a fee. The IRS argued that by creating the PTIN requirement, it had created a “thing of value” which allowed it to charge a fee, citing 31 U.S.C. §9701(b). However, the plaintiffs claimed that the PTIN requirements are arbitrary and capricious under the Administrative Procedure Act or, alternatively is unlawful as an unauthorized exercise of licensing authority over tax return preparers because the fee does not confer a “service or thing of value.” The trial court determined that the IRS can require the exclusive use of a PTIN because it aids in the identification and oversight of preparers and their administration. However, the trial court held that the IRS cannot impose user fees for PTINs. The trial court determined that PTINs are not a “service or thing of value” because they are interrelated to testing and eligibility requirements and the accuracy of tax returns is unrelated to paying a PTIN fee. A prior federal court decision held that the IRS cannot regulate tax return preparers (Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014)), thus charging a fee for a PTIN would be the equivalent of imposing a regulatory licensing scheme which IRS cannot do. The trial court determined that prior caselaw holding that the IRS can charge a fee for a PTIN were issued before the Loving decision, and

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are no longer good law. On appeal, the appellate court vacated the trial court’s decision and remanded the case. The appellate court determined that the IRS does provide a service in exchange for the PTIN fee which the court defined as the service of providing preparers a PTIN and enabling preparers to place the PTIN on a return rather than their Social Security number and generating and maintaining a PTIN database. Thus, according to the appellate court, the PTIN fee was associated with an “identifiable group” rather than the public at large and the fee was justified on that ground under the Independent Offices Appropriations Act. The appellate court also believed the IRS claim that the PTIN fee improves tax compliance and administration. The appellate court remanded the case for further proceedings, including an assessment of whether the amount of the PTIN fee unreasonable exceeds the costs to the IRS to issue and maintain PTINs. Montrois, et al. v. United States, No. 17-5204, 2019 U.S. App. LEXIS 6260 (D.C. Cir. Mar. 1, 2019), vac’g,. and rem’g., Steele v. United States, 260 F. Supp. 3d 52 (D. D.C. 2017).

9. Without Sufficient Contact, State Can’t Tax Trust. The trust at issue, a revocable living trust, was created in 1992 with a situs of New York. The primary beneficiaries were the settlor’s descendants. None of the descendants lived in North Carolina at the time of the trust’s creation. The trust was divided into three separate trusts in 2002, one for each of the settlor’s children. The beneficiary of one of the sub-trusts was a North Carolina resident at that time. The trustee was replaced in 2005 with a successor trustee who resided in Connecticut. North Carolina tax returns were filed for tax years 2005-2008 for the accumulated trust income, that was distributed to the beneficiaries, including the non-North Carolina beneficiaries. In 2009, the trust filed a claim for a refund of North Carolina taxes in an amount slightly exceeding $1.3 million. The trust claimed that N.C. Gen. Stat. §105-160.2, which assesses tax on the amount of taxable income of the estate or trust that is for the benefit of a North Carolina resident, was unconstitutional on due process and Commerce Clause grounds. The defendant denied the claim, and the hearing officer later dismissed the case for lack of jurisdiction. The trial court dismissed the request for injunctive relief with respect to the refund claim, but denied the defendant’s motion to dismiss the constitutional claims. The trial court then granted summary judgment for the trust on the constitutional claim and ordered the defendant to refund the taxes paid on its accumulated income. On appeal, the appellate court affirmed. The court determined that the trust failed to have sufficient minimum contacts (as required by the Due Process Clause) with North Carolina to subject the trust to North Carolina income tax. The court cited both International Shoe Co. v. Washington, 326 U.S. 310 (1945) and Quill Corp. v. North Dakota, 504 U.S. 298 (1992) to support its position on this point. The trust did not have any physical presence in the state during the tax years at issue, contained no North Carolina property or investments, had no trust records that were created or kept in North Carolina, and the place of trust administration was not in North Carolina. Basing the imposition of state tax on a beneficiary’s domicile, by itself, did not establish sufficient minimum contacts with the state to satisfy the Due Process Clause and allow North Carolina to tax a non-North Carolina trust. The appellate court held that Brooke v. Norfolk, 277 U.S. 27 (1928) was controlling. In that case, a Maryland resident created a testamentary trust with a Maryland situs for a Virginia beneficiary. Virginia assessed tax on the trust corpus, but the Court held the assessment to be unconstitutional. On further review, the state Supreme Court affirmed, also noting that a key to the case was that the trust beneficiary did not receive trust distributions during the years at issue. As such, the North Carolina statute violated the Due Process Clause of the U.S. Constitution. On January 11, 2019, the U.S. Supreme Court agreed to hear the case. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 789 S.E.2d 645 (N.C. Ct. App. 2016), aff'd., 814 S.E.2d 43 (N.C. 2018), pet. for cert. granted, No. 18-457, 2019 U.S. LEXIS 574 (U.S. Sup. Ct. Jan. 11, 2019).

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Note: In a unanimous decision, the U.S. Supreme Court affirmed, holding that the North Carolina law violated Due Process. North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, No. 18-457, 2019 U.S. LEXIS 4198 (U.S. Sup. Ct. Jun. 21, 2019). The Court noted that to satisfy constitutional Due Process, a taxpayer must have “some minimum connection” with the state, and that a rational relationship must exist between the income the state wants to tax and the state. There must be a fiscal relationship to benefits that the state provides. The Court determined there was an insufficient nexus between the North Carolina beneficiary and the state for the state to have jurisdiction to tax the trust. The beneficiary never received an income distribution from the trust for the years at issue and didn’t have a right to demand trust distributions and had no power of assignment. It was the trustee, under the terms of the trust, that had the sole discretion over distributions. Indeed, the trust assets could ultimately end up in the hands of other beneficiaries. But, the Court did not foreclose the ability of a state to tax trust income where the trust gives the resident beneficiary a certain right to trust income.

10. Court Rules on Willful FBAR Reporting Failure Standard. The plaintiff is the CEO of a company that manufactures and distributes generic medications. In the early 1970s, he traveled internationally for business and opened a savings account in Switzerland which he used to access funds while traveling abroad. The savings account was later converted into an investment account, which resulted in a second account being created. It was unclear whether the plaintiff knew of the creation of the second account. From 1972-2007, the plaintiff had an accountant who prepared his returns, but didn't inform him of the requirement to report the foreign accounts until the mid-1990s. At that time, the accountant informed the plaintiff to take no action and have his estate deal with the matter upon the plaintiff's death. The accountant died in 2007 and the plaintiff hired a new accountant. The plaintiff's 2007 return, prepared with the same information that the plaintiff had always provided his previous accountant, disclosed the presence of one of the foreign accounts containing $240,000, but did not disclose the other account that contained about $2 million. The plaintiff also filed amended returns for 2004 to the present time paying taxes on the gains on the Swiss accounts. The plaintiff also closed the Swiss accounts in 2008. The IRS notified the plaintiff in 2011 that he was being audited, and asserted an FBAR penalty. The plaintiff paid the $9,757.89 penalty (for a non-willful violation) and sued for a refund. The IRS counterclaimed for what it claimed was the full amount of the penalty for a willful violation - $1,007,345.48. The trial court denied summary judgment for both parties and conducted a bench trial on the issue of the plaintiff's willfulness under 31 U.S.C. §5314 and whether the IRS satisfied its burden of proof regarding the calculation of the penalty amount for a willful violation (greater of $100,000 or 50 percent of the balance in the account at the time of the violation of 31 U.S.C. §5321(a)(5)(B)(i)) with no reasonable cause exception. The trial court noted that there was no precise statutory definition of "willful," but that the federal courts have required either a knowing or reckless failure to file an FBAR. The trial court determined that the failure to file an FBAR for 2007 was not willful based on the facts. Rather, the trial court determined that the plaintiff simply committed an unintentional oversight or a negligent act. The trial court determined that did not do anything to conceal or mislead and inadvertently failed to report the second account on the FBAR. The trial court noted that the plaintiff had retained an accounting firm to file amended returns and rectify the issue before learning of an IRS audit. The trial court determined that there was no tax avoidance motive and reasoned that the plaintiff's conduct was not the type intended by the Congress or IRS to constitute a willful violation. The trial court also determined that the penalty amount that the plaintiff paid had been illegally exacted and ordered the IRS to return those funds to the plaintiff. On further review, the appellate court held that it

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did not have exclusive jurisdiction under 28 U.S.C. §1295(a)(2) to review appeals from the trial court’s final judgment on a claim against the government for recovery of a civil FBAR penalty. The appellate court also concluded that the standard of willfulness for FBAR purposes referred to the civil willfulness standard, which included both knowing and reckless conduct. Accordingly, the appellate court remanded the case because it was not clear whether the trial court judged the taxpayer’s conduct under this standard. Bedrosian v. United States, 17-3525, 2018 U.S. App. LEXIS 36146 (3d Cir. Dec. 21, 2018), remanding No. 15-5853, 2017 U.S. Dist. LEXIS 154625 (E.D. Pa. Sept. 20, 2017).

11. IRS Provides More Ways To Avoid “Roberts” Tax. The IRS has identified additional “hardship” exemptions from the penalty (“Roberts”) tax of I.R.C. §5000A for a taxpayer failing to have the mandated government-approved health insurance under Obamacare for 2018. The additional exemptions apply when the taxpayer establishes that he has experienced financial or domestic circumstances causing a significant, unexpected increase in essential expenses barring the taxpayer from obtaining health insurance coverage. An exemption also applies if the taxpayer can establish that acquiring health insurance would have cause the taxpayer to experience serious deprivation of food, shelter, clothing or other necessities. In addition, the IRS specified that an exemption applies if the taxpayer establishes that any other circumstance prevented the taxpayer from obtaining health insurance coverage. Notice 2019-5, 2019-2 IRB.

12. IRS Issues Guidance on TCJA Depreciation Rules. In a Revenue Procedure, the IRS noted that for property placed in service after 2017 qualified improvement property as defined by I.R.C. §168(e)(6) as defined in I.R.C. §168(k)(3) in effect as of December 21, 2017. Also eligible is an improvement to nonresidential real property as defined in I.R.C. §168(e)(2)(B) if the improvement is placed in service after the date the nonresidential real property was first placed in service by any person, is I.R.C. §1250 property and is either a roof, HVAC system, fire protection and alarm system or security system. Also provided is an optional depreciation table for 30-years ADS property, and guidance on how to handle the change to ADS depreciation for certain farming assets of electing farm and real property businesses. Rev. Proc. 2019-8, 2019-3 I.R.B.

13. IRS and Treasury Reach Different Conclusions on Brokerage Services As SSBs. Prop. Treas. Reg. §1.199A-5(b)(2)(x) states that “the performance of services in the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities (as defined in section 475(c)(2)) for a commission or fee. This includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers.” Thus services provided by real estate agents and brokers or insurance agents and brokers do not constitute an SSB. However, in the draft of Publication 535, the IRS states that a specified service business for purposes of I.R.C. §199A include, “Brokerage services, including arranging transactions between a buyer and a seller for a commission or fee such as stock brokers, real estate agents and brokers, insurance agents and brokers, and intellectual property brokers. Thus, Pub. 535 includes categories that the proposed treasury regulation excludes. Publication 535 also includes intellectual property brokers as an SSB, but the proposed regulations don’t make any mention of whether intellectual property brokers are included. IRS Draft Publication 535.

14. IRS Provides Guidance on Market Facilitation Payments. The IRS National Office has issued guidance to IRS national program executives and managers concerning certain tax issues involving the issuance by the USDA of Market Facilitation Payments

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(MFPs). The IRS noted that MFPs are direct payments to farmers of certain crops that have been adversely affected by tariffs. The IRS noted that the purpose of the MFPs is to make up for depressed crop prices caused by tariffs and that the payments are tied to what a farmer actually produced in 2018. The IRS noted that MFPs are intended to compensate a farmer for lost profits and, as such, are included in gross income in accordance with I.R.C. §61(a). See also Rev. Rul. 73-408, 1973-2 C.B. 15; Rev. Rul. 68-44, 1968-1 C.B. 191. The IRS also determined that MFPs are similar to counter- cyclical and price-loss payments authorized under prior Farm Bills which a farmer/recipient had to include in gross income. In addition, the IRS determined that MFPs are included in net earnings from self-employment and, thus, subject to self- employment tax because the MFPs are tied to earnings derived by a farmer from the farming business. See, e.g., Ray v. Comr., T.C. Memo. 1996-436. While the IRS did not comment on the issue, MFPs are also not deferrable as are crop insurance payments paid for actual physical destruction to the taxpayer’s crops. As noted, MFPs are payments for lost profit rather than to compensate a producer for physical damage or destruction to crop, or the inability to plant (the requirement for deferability under I.R.C. §451(f)). IRS Legal Advice to Program Managers, PMTA-2018-21 (Dec. 10, 2018).

15. Elimination of Tax Associated With Individual Mandate Renders Health Care Law Invalid. The Tax Cuts and Jobs Act of 2017 reduces to zero, effective for tax years beginning after 2018, the tax rate of the payment for an individual failing to have governmentally-acceptable health insurance in accordance with the 2010 Patient Protection and Affordable Care Act (i.e., “Obamacare). In National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012), the Supreme Court upheld Obamacare as constitutional on the sole basis that the individual mandate, as the linchpin to the entire law, was constitutional under the taxing power of the Congress because the payment required for not having government-acceptable health insurance was a tax rather than a penalty. In the present case, the court noted that the payment was distinct from the individual mandate and determined that the individual mandate was no longer constitutional as of 1/1/2019 because it would no longer trigger any tax. In addition, because the individual mandate was the linchpin of the entire law, the provision could not be severed from the balance of the law. As a result, as of January 1, 2019, Obamacare no longer has any constitutional basis and is invalidated as being unconstitutional. Texas v. United States, No. 4:18-cv-00167-O, 2018 U.S. Dist. LEXIS 211547 (N.D. Tex. Dec. 14, 2018).

16. IRS Lien Not Eliminated by Bankruptcy Filing. The defendants had unpaid taxes and the IRS assessed a deficiency and penalties and filed Notices of Federal Tax Liens with the local county with respect to the defendants’ property in that county. The defendants then filed Chapter 7 bankruptcy and the bankruptcy court granted an Order of Discharge. The defendants chose the state (MA) bankruptcy exemptions and claimed a $500,000 homestead exemption which allowed them to exempt up to $500,000 of value from certain creditor liens and enforcement actions. The IRS sued to enforce the tax liens by selling the defendants’ property. The defendants claimed that the enforcement of the liens was barred because the property subject to the liens was exempt property in the bankruptcy estate. The trial court disagreed, holding that the state bankruptcy code exemption has no effect on the enforceability of federal tax liens citing as authority United States v. Rodgers, 461 U.S. 677 (1983) and United States v. Craft, 535 U.S. 274 (2002). The defendants also claimed that the court’s Order of Discharge barred the foreclosure sale. Again, the trial court disagreed. The trial court noted that the filing of Chapter 7 does not render the federal tax liens unenforceable but may relieve the debtor of personal liability. However, the trial court denied the motion of the IRS for partial final judgment because the trial court had not

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yet made findings concerning the order of priorities for distribution of sale proceeds. United States v. Seeley, No. 16-cv-10935-ADB, 2018 U.S. Dist. LEXIS 191082 (D. Mass. Nov. 8, 2018).

17. Obamacare Payment Not a “Tax” – Federal District Court Lacked Jurisdiction. The plaintiff is a self-administered, self-insured employee health and welfare benefit plan created under a collective bargaining agreement. The plaintiff paid over $1 million into the "Transitional Reinsurance Program"—a feature of the ACA administered by the Department of Health and Human Services (HHS) to stabilize the insurance market for 2014 as a result of the destabilization of the market caused by Obamacare. The plaintiff sued in federal district court for a refund on the basis that the HHS regulations improperly required the plaintiff to pay into the program. The plaintiff claimed that the payment constituted a “tax” which gave the district court jurisdiction over the case via 28 U.S.C. §1346(a)(1). The trial court disagreed, citing the U.S. Supreme Court opinion of National Federation of Independent Business v. Sebelius, . Accordingly, the trial court determined that it lacked jurisdiction and granted the government’s motion to dismiss. The appellate court affirmed. The appellate court reasoned that 28 U.S.C. §1346(a)(1) had to be read in conjunction with I.R.C. §7421 and §7422 to mean that the federal district courts have jurisdiction over suits to recover “any internal revenue tax” collected by the IRS under the authority of the Internal Revenue Code. Here, the appellate court noted, the plaintiff made a “payment” to the HHS rather than the IRS. Thus, the “payment” was not an “internal revenue tax.” The appellate court also determined that the Congress had provided a remedy for the plaintiff to recover allegedly illegal fees and exactions by mean of jurisdiction over such cases in the Court of Federal Claims. Electrical Welfare Trust Fund v. United States, No. 17-1937, 2018 U.S. App. LEXIS 29856 (4th Cir. Oct. 23, 2018).

18. Beginning in 2019, A Religious Exemption From “Roberts Tax” Applies. Starting in 2019, a religious exemption from the individual mandate contained in Obamacare will apply. The mandate forces taxpayers to have a government-approved amount of “minimal acceptable health insurance coverage” or face an additional penalty tax (i.e., the “Roberts Tax”). The individual mandate, under the Tax Cuts and Jobs Act (TCJA), is eliminated for tax years beginning after 2018, but the employer mandate remains. The religious exemption applies to individuals who are members of a religious sect or division which is not described in Sec. 1402(g)(1) of Obamacare who rely solely on a religious method of healing, and for whom the acceptance of medical health services is not consistent with their religious beliefs. H.R. 6, amending I.R.C. §5000A(d)(2)(A), effective for tax years beginning after 2018, signed into law on Oct. 24, 2018.

19. TCJA Does Not Impact Concrete Foundation Repair Safe Harbor. Based on the conclusions of an investigation conducted by the Connecticut Attorney General’s Office that Pyrrhottite, a mineral in stone aggregate that is used in making concrete, causes concrete to prematurely deteriorate, the IRS has provided a safe harbor for deducting a casualty loss to a taxpayer’s home based on a deteriorating concrete foundation. Under the safe harbor, a taxpayer who pays to repair damage to the taxpayer’s personal residence caused by a deteriorating concrete foundation may treat the amount paid as a casualty loss in the year of payment. Under the safe harbor, the term “deteriorating concrete foundation” means a concrete foundation that is damaged as a result of the presence of the mineral pyrrhotite in the concrete mixture used to pour the foundation. The safe harbor is available to a Connecticut taxpayer who has obtained a written evaluation from a licensed engineer indicating that the foundation was made with defective concrete, and has requested and received a reassessment report that shows the reduced reassessed value of the residential property based on the written evaluation from the engineer and an inspection pursuant to Connecticut

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Public Act No. 16-45 (Act). The safe harbor also is available to a taxpayer whose personal residence is outside of Connecticut, provided the taxpayer has obtained a written evaluation from a licensed engineer indicating that the foundation was made with defective concrete containing the mineral pyrrhotite. The amount of a taxpayer’s loss resulting from the deteriorating concrete foundation is limited to the taxpayer’s adjusted basis in the property. In addition, the IRS noted that the amount of the loss may be limited depending on whether the taxpayer has a pending claim for reimbursement (or intends to pursue reimbursement) of the loss through property insurance, litigation, or otherwise. A taxpayer who does not have a pending claim for reimbursement, and who does not intend to pursue reimbursement, may claim as a loss all unreimbursed amounts (subject to the adjusted basis limitation) paid during the taxable year to repair damage to the taxpayer’s personal residence caused by the deteriorating concrete foundation. A taxpayer who has a pending claim for reimbursement, or who intends to pursue reimbursement, may claim a loss for 75 percent of the unreimbursed amounts paid during the taxable year to repair damage to the taxpayer’s personal residence caused by the deteriorating concrete foundation. The IRS noted that taxpayer who has been fully reimbursed before filing a return for the year the loss was sustained may not claim a loss, and that amounts paid for improvements or additions that increase the value of the taxpayer’s personal residence above its pre-loss value are not allowed as a casualty loss. Only amounts paid to restore the taxpayer’s personal residence to the condition existing immediately prior to the damage qualify for loss treatment. The IRS noted that a taxpayer claiming a casualty loss under the safe harbor must report the amount of the loss on Form 4684 (“Casualties and Thefts”) and must mark “Revenue Procedure 2017-60” at the top of that form. Taxpayers are subject to the $100 limitation imposed by § 165(h)(1) and the 10-percent-of-AGI limitation imposed by §165(h)(2). Taxpayers not choosing to apply the safe harbor treatment are subject to all of the generally applicable provisions governing the deductibility of losses under § 165. Thus, taxpayers not utilizing the safe harbor must establish that the damage, destruction, or loss of property resulted from an identifiable event that is sudden, unexpected, and unusual, and was not the result of progressive deterioration. Rev. Proc. 2017-60, 2017-50 I.R.B. As additional guidance, IRS, in early 2018, stated that taxpayers cannot claim the safe harbor and treat amounts paid to fix a foundation as a casualty loss for the 2017 tax year as late as a timely filed Form 1040X for the 2017 tax year. Rev. Proc. 2018-14, 2018-9 I.R.B., modifying Rev. Proc. 2017-60, 2017-50 I.R.B. In late 2018, the IRS clarified that the Tax Cuts and Jobs Act (TCJA) has no impact on the safe harbor. Thus, casualty loss deductions that qualify for the safe harbor under Rev. Proc. 2017-60 and Rev. Proc. 2018-14 will be treated as trade or business deductions and can create or increase a taxpayer’s NOL (which can be carried back two years and forward 20, and offset 100 percent of the taxpayer’s taxable income in those years). Such NOLs are treated as arising in or before the 2017 tax year. IRS letter to Rep. Courtney (D-CT) from IRS Commissioner Rettig (Oct. 2018).

20. Qualified Opportunity Zone Fund Investment Regulations Issued. The Treasury and the IRS on I.R.C. have issued guidance on I.R.C. §1400Z-2 that is intended to describe and clarify the requirements that a taxpayer must satisfy to defer gain recognition by investing in a qualified opportunity fund (QOF). The guidance specifies that a corporation or a partnership can self-certify as a QOF. The guidance also provides proposed regulations on other requirements that a corporation or partnership must satisfy to be a QOF. The IRS also provided guidance on the “original use” and “substantial improvement” requirements for property that a QOF purchases after 2017 in a qualified opportunity zone. In addition, the proposed regulations address self- certification and valuation of fund assets and include guidance on the type of qualifying opportunity zone business investment. The proposed regulations also provide

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guidance on the types of gains that may be deferred; the time by which investments must be made; and the manner in which investors make the election to defer gains. As for the purchase of an existing building in a qualified opportunity zone, the IRS provided guidance on whether the building would meet the “original use” requirement and how a substantial improvement could be made to an existing building. The preamble to the proposed regulations state that regulations will be forthcoming on the statutory meaning of “substantially all” and information reporting requirements. Rev. Rul. 2018-29, IR 2018-206 and Prop. Reg. 115420-18 (Oct. 19, 2018).

21. IRS Lists Areas Eligible For Extended Replacement Period. The IRS has issued its annual Notice announcing those areas that are eligible for an extension of the replacement period for livestock that farmers and ranchers must sell because of severe weather conditions (Notice 2018-79, 2018-42 I.R.B). I.R.C. § 1033 allows nonrecognition of gain for involuntarily converted livestock that is replaced with property similar or related in service or use. A farmer or rancher who sells an excess number (more than is typically sold in the normal course of business) of livestock (other than poultry) that have been held for draft, breeding, or dairy purposes can treat the excess sold as an involuntary conversion if the livestock are sold or exchanged solely on account of drought, flood, or other weather-related conditions. While the livestock must be replaced with "like-kind" livestock (normally within four years from the close of the first tax year in which any part of the gain from the conversion is realized), the Treasury has the discretion to extend the replacement period for taxpayers impacted by prolonged drought. In those areas, the replacement period is extended until the end of the taxpayer's first tax year ending after the first drought-free year. So, if an area is designated as not having a drought-free year, the extended replacement period applies. Livestock owners in the listed areas who were anticipating that their replacement period would expire at the end of 2018 now have until the end of 2019 to replace the involuntarily converted livestock. The relief applies to any farm located in a county in one of the 41 states (and the District of Columbia) as having suffered exceptional, extreme, or severe drought conditions by the National Drought Mitigation Center during any weekly period between September 1, 2017, and August 31, 2018. The Kansas counties included are Allen, Anderson, Atchison, Barber, Barton, Bourbon, Brown, Butler, Chase, Chautauqua, Cherokee, Clark, Clay, Coffey, Comanche, Cowley, Crawford, Dickinson, Doniphan, Douglas, Edwards, Elk, Ellis, Ellsworth, Finney, Ford, Franklin, Geary, Gove, Grant, Gray, Greeley, Greenwood, Hamilton, Harper, Harvey, Haskell, Hodgeman, Jackson, Jefferson, Johnson, Kearny, Kingman, Kiowa, Labette, Lane, Leavenworth, Lincoln, Linn, Lyon, McPherson, Marion, Marshall, Meade, Miami, Montgomery, Morris, Morton, Nemaha, Neosho, Ness, Osage, Osborne, Ottawa, Pawnee, Pottawatomie, Pratt, Reno, Rice, Riley, Rush, Russell, Saline, Scott, Sedgwick, Seward, Shawnee, Stafford, Stanton, Stevens, Sumner, Trego, Wabaunsee, Wallace, Wichita, Wilson, Woodson, and Wyandotte. IRS Notice 2018-79, 2018-42 I.R.B.

22. No IRS Priority on Obamacare Penalty Tax. The debtor filed Chapter 13 bankruptcy and the IRS claimed priority position with respect to the debtor’s tax liability, including the debtor’s liability for “shared responsibility payment” under I.R.C. §5000 created as part of Obamacare. Under Chapter 13, the debtor’s reorganization plan must provide for the full payment of all claims entitled to priority under 11 U.S.C. §507. Obamacare mandates that individuals obtain health care coverage during the tax year or pay a “shared responsibility payment,” also referred to as the “individual mandate penalty” or the “Roberts tax” (so-named after Chief Justice Roberts that construed the payment as a “tax” so as to uphold the constitutionality of Obamacare in National Federation of Independent. Business. v. Sebelius, 567 U.S. 519 (2012)). Based on the Supreme Court’s 2012 opinion, the IRS asserted priority over the debtor’s outstanding obligation

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to make the payment in accordance with 11 U.S.C. §507(a)(8) which affords the IRS priority status to “allowed unsecured claims of governmental units” (including an excise tax on a transaction) on the basis that the payment was an excise tax. The IRS noted that in Sebelius, the Supreme Court noted that the penalty, once imposed, had to be reported on the taxpayer’s return and the IRS had to assess and collect it in the same manner as taxes in general. The debtors objected on the grounds that the payment was not a “tax” that entitled the IRS to priority under 11 U.S.C. §507(a)(8), but was merely a penalty for failure to obtain the government-mandated health insurance. The court noted that characterizations in the Internal Revenue Code are not dispositive in the bankruptcy context, but that an exaction is a tax when it lays a pecuniary burden on an individual or property for the purpose of supporting the government. On that point, the court noted that the “Roberts tax” had been estimated to generate about $4 billion annually by 2017. However, the court noted that the burden of the penalty on any particular person was “light,” contained no “scienter” requirement and the IRS had no criminal enforcement authority to enforce payment. Thus, failure to pay the penalty was not “unlawful.” In addition, the court reasoned that the payment was not a tax on the production or use of goods, but was a penalty imposed for doing nothing in terms of health insurance (note: the court glossed over the point that a penalty imposed on persons that self-insure is a “tax” in every sense of the word to those persons). Thus, it was a penalty on a condition or status rather than an activity. Accordingly, the penalty could not be an excise tax because it wasn’t imposed on the enjoyment of a privilege (although being free to self-insure is a privilege that such persons enjoy). The court was not willing to take an expansive view of the definition of an excise tax. In addition, the court noted that 11 U.S.C. §507(a)(E)(8) requires that an excise tax be imposed on a transaction for the IRS to have priority. However, the court concluded, the penalty was triggered not on a transaction, but on the lack of a transaction. Thus, the court disallowed as a priority unsecured claim the IRS claim attributable to the debtor’s outstanding “shared responsibility payment” imposed under I.R.C. §5000A in the amount of $1,043, plus $9.18 in interest. The court allowed the claim as a nonpriority unsecured claim. In so holding, the court followed the precedent set forth in In re Parrish, 583 B.R. 873 (Bankr. E.D. N.C. 2018) and In re Chesteen, No. 17-11472, 2018 Bankr. LEXIS 360, 2018 WL 878847 (Bankr. E.D. La. Feb. 9, 2018). In re Huenerberg, No. 17-28645, 2018 Bankr. LEXIS 2992 (Bankr. E.D. Wisc. Sept. 28, 2018).

23. Reasonable Cause May Exist For Faulty Form 8283. The petitioner, an LLC taxed as a partnership, donated a permanent conservation easement to a land trust. The easement was placed on a wooded tract. The filed Form 8283 did not include any cost or adjusted basis information, and the IRS denied the deduction due to the petitioner’s failure to substantially comply with Treas. Reg. §1.170A-14(c). The petitioner asserted that its omission was reasonable because it did not know what to report, and that the petitioner ultimately cured the defect in Form 8283 by later supplying cost basis information to the IRS during audit. The petitioner also claimed that it had effectively disclosed the required information elsewhere on its return. The Tax Court disagreed with the petitioner, noting that the Form 8283 information was necessary to alert the IRS as to whether further investigation was needed. The Tax Court determined that the petitioner had made the conscious decision to not supply the required information on Form 8283. However, the Tax Court held that the petitioner did have reasonable cause for relying on a consulting firm that, in turn, relied on an outside firm. Such qualified reasonable cause under I.R.C. §170(f)(11), the Tax Court held, raised material fact questions that the Tax Court could not presently resolve. Belair Woods, LLC, et al. v. Comr., T.C. Memo. 2018-159.

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24. IRS Can Continue Voluntary Annual Filing Season Program. Of the four categories of persons who prepare returns for a fee, “unenrolled” preparers have not historically been subject to licensing requirements. However, in 2011, the IRS developed a rule requiring an unenrolled preparer to become a “registered tax return preparer” by paying a fee, passing a one-time competency exam and completing a prescribed course of continuing education each year. 31 C.F.R. §§10.4(c); 10.5(b)-(c); 10.6(e)(3). However, the rule was invalidated on the basis that the IRS lacked the statutory authority to regulated unenrolled preparers. Loving v. IRS, 917 F. Supp. 2d 67 (D. D.C. 2013). The IRS was permitted, however, to continue its testing and continuing- education centers, but couldn’t require enrollment, test-taking or payment of a fee for those services. The trial court’s decision was affirmed on appeal. Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2013). The IRS continued, consistent with the court’s opinion, its testing and continuing education programs as part of a Voluntary Annual Filing Season Program (“Program”) in accordance with Rev. Proc. 2014-42, 2014-29 I.R.B. 192. When an unenrolled preparer completes the Program, the preparer receives a “Record of Completion” and is then listed in the IRS online directory of tax preparers along with all other preparers. Such unenrolled preparers then gain a limited right to represent in the initial stages of the audit of a return that such person has prepared, just like they could before the program was established. The plaintiff challenged the ability of the IRS to conduct the Program. The trial court dismissed the case for lack of standing. On appeal, the court reversed and remanded. On remand, the trial court again held that the plaintiff lacked standing on the basis that what the plaintiff was attempting to do was merely limit competition. The trial court dismissed the case. On appeal, the appellate court reversed on the standing issues and, rather than remanding the case, decided it on the merits. The court determined that the plaintiff had standing based on 31 U.S.C. §330(a) because that provision gives the Treasury the power to regulate character and reputation (among other things) of the parties that practice before it and consequently, the obligations of the plaintiff’s members to supervise unenrolled agents. On the merits, the appellate court held that the 31 U.S.C. §330(a) authorized the IRS to operate the Program. The appellate court also rejected the plaintiff’s claim that the revenue procedure establishing the program should have been subjected to notice and comment requirements of the Administrative Procedure Act (APA). The appellate court determined that the revenue procedure was merely interpretive and not legislative and, thus, not subject to the APA. The appellate court also determined that the Program was not arbitrary and capricious. American Institute of Certified Public Accountants v. Internal Revenue Service, No. 16-5256, 2018 U.S. App. LEXIS 22583 (D.C. Cir. Aug. 14, 2018), rev’g., 199 F. Supp. 3d 55 (D. D.C. Aug. 3, 2016).

25. Treasury Issues Final Regulations on Reporting Charitable Contributions. In 2008, the Treasury issued proposed regulations governing the tax reporting of charitable contributions. Now, the Treasury has issued final regulations on the topic that largely adopt the proposed regulations but do make some modifications. Under the final regulations, a donor must maintain records of charitable contributions. For cash contributions, the donor must retain a canceled check, or other reliable written record showing the donee’s name, date of contribution and amount. While some charitable organizations provide a blank form for donors to complete, the Preamble to the final regulations specific that the blank form is insufficient to satisfy record keeping requirements for tax purposes to substantiate the donation. For contributions over $250, the donee organization must provide a contemporaneous written acknowledgment of the gift. I.R.C. §170(f)(8). In addition, the final regulations state that a donor may be required to complete and submit a Form 8283, depending on the type of gift and the amount. The Preamble to the final regulations provides that the Form 8283 itself does not meet the contemporaneous written acknowledgment requirement. Rather, a separate written acknowledgment is required. The final

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regulations note that appraisals are required for non-money contributions over $5,000, and state that an appraiser can meet the requisite education and experience requirements by successfully completing professional or college-level coursework. But, mere attendance is not sufficient, and evidence of successful completion is required. For contributions exceeding $500,000 in value, the appraisal must be attached to the donor’s income tax return. Under the final regulations, the appraisal is not attached just to the return of the contribution year but must also be attached to any return involving a carryover year (due to the limitation on the charitable contribution deduction). TD 9836. Substantiation and Reporting Requirements for Cash and Noncash Charitable Contribution Deductions (Jul. 27, 2018).

26. Court Invalidates FBAR Regulation. The plaintiff had money in a Swiss bank account in 2007, but failed to timely file Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts – or FBAR). The plaintiff claimed that she did not willfully fail to file the FBAR, but learned of her responsibility to file the Form via her mother in 2009 and that she relied on her accountant to make application to the IRS’ Offshore Voluntary Disclosure Program (OVDP). If the plaintiff qualified for the OVDP her FBAR penalties could be reduced to 20 percent of the account balance rather than 50 percent. The IRS noted that if the taxpayer filed an amended return along with an FBAR and paid the related tax and interest for the previously unreported foreign income, the plaintiff could be criminally prosecuted. The plaintiff did not apply to the OVDP, but did file an amended return. The IRS asserted the 50 percent penalty under 31 U.S.C. §5321(a)(5) which modified prior law on this point and increased the penalty for the greater of $100,000 or 50 percent of the balance in the account at the time of the violation. The IRS had not updated its regulation on the issue which it promulgated under the prior version of the statute that had the lower penalty. While prior court decisions had upheld the regulation as being consistent with the new statute resulting in the lower level of penalty being applied, the court in this case invalidated the regulation as inconsistent with the mandatory language of the modified statute requiring the higher penalty amount. In addition, the court determined that the taxpayer’s failure to file the FBAR was willful. Norman v. United States, No. 15-872T, 2018 U.S. Claims LEXIS 888 (Fed. Cl. Jul. 31, 2018).

27. Joint Returns Containing Forged Signature Were Valid and Cannot Be Revoked. The plaintiff and her husband were married until his death in 2011. He took care of all financial matters for the family. In late 2009, the husband filed married-filing- jointly returns for the 2001-through 2006 tax year. In 2010, the husband filed a joint return for the 2007 tax year. The husband signed the returns and forged his wife’s signature on the returns. The plaintiff had no knowledge of her husband signing her names to the returns and did not consent. The husband paid the taxes in connect with the late-filed returns. Upon his death in 2011, the plaintiff learned of the jointly filed returns and filed married filing separate returns for the 2001-2007 tax years and sought a refund of part of the taxes paid for tax years 2001-2007. The IRS disallowed the refund and the court agreed. The court held that it was undisputed that the plaintiff intended to file joint tax returns for the 2002 through 2007 tax years with her husband and that the joint tax returns for those years, filed in 2009 and 2010, were valid. As a result, the plaintiff could not revoke the joint returns in order to pay a lesser amount pursuant to a separate return filed years later. The plaintiff ultimately conceded that she was not entitled to a refund for the 2001 tax year, and the court granted summary judgment to the IRS on all other claims. the defendant is entitled to summary judgment on the claims arising out of those tax years. Coggin v. United States, 1:16-CV-106, 2018 U.S. Dist. LEXIS 119104 (D. N.C. Jul. 17, 2018).

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28. IRS Can’t Impose Revised Statutory FBAR Penalty. The IRS assessed civil penalties against the plaintiff for the plaintiff’s repeated and willful failures to timely file Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts – or FBAR). The IRS assessed penalties of $196,082 for another four FBAR violations, and smaller penalties in 2009 and 2010. The IRS referenced 31 U.S.C. §5321(a)(5) and 31 C.F.R. §1010.820(g)(2) when assessing the penalties. The IRS moved to reduce the penalties to judgment, and the plaintiff moved for summary judgment on the basis that the IRS didn’t properly apply the law when calculating the amount of the penalties. The plaintiff argued that the IRS was limited by a prior version of 31 U.S.C. §5321(a)(5) which allowed the Treasury Secretary to impose civil or monetary penalties amounting to the greater of $25,000 or the balance of the unreported account up to $100,000. A related Treasury regulation reiterated the statute. In 2002, the Treasury delegated penalty enforcement authority to the Financial Crimes Enforcement Network (FinCEN), but the related regulations were not affected. Shortly thereafter, the FinCEN delegated penalty assessment authority to the IRS. In 2004, the Congress amended 31 U.S.C. §5321(a)(5) to increase the maximum civil penalties that could be assessed for willful failure to file an FBAR form. Under the revision, applicable for the years in issue in the present case, the civil monetary penalties for willful failure to file the FBAR were increased to a minimum of $100,000 and a maximum of 50 percent of the balance in the unreported account at the time of the violation. However, the underlying regulations were not changed to comport with the new statute, and IRS relied on the new statute for assessing the penalties against the plaintiff. The court agreed with the plaintiff, noting that the revised statute only set a penalty ceiling but did not set a floor and that the regulation was consistent with both versions of the statute, and that the regulation had not been amended to reflect the higher penalties authorized by the modified statute. As such, the IRS acted arbitrarily and capriciously in not applying the regulation to cap the penalties assessed against the plaintiff at $100,000. The court specifically noted that the IRS had 14 years to revise the regulation and failed to do so, which indicated to the court that the IRS had made a conscious decision to limit the penalties to the $100,000 cap. United States v. Colliot, No. AU-16-CA-01281-SS, 2018 U.S. Dist. LEXIS 83159 (W.D. Tex. May 16, 2018). For another case that reached the same conclusion, see, United States v. Wadham, No. 17-CV-1287-MSK, 2018 U.S. Dist. LEXIS 119910 (D. Co. Jul. 18, 2018).

29. No Deduction For Pre-Paid Property Taxes That Haven’t Yet Been Assessed. The IRS has informed the state of New Jersey (NJ) that its actions ordering municipalities to accept payments for 2018 personal property taxes in calendar year 2017 for the purpose of deducting those payments in 2017, will not provide a federal income tax deduction to the payor for property taxes that have not yet been assessed under state law as of the end of 2017. The IRS pointed out that a deduction for state and local real property taxes is allowed if the tax is both assessed and paid in the tax year. See, e.g., Estate of Hoffman v. Comr., 8 Fed. Appx. 262 (4th Cir. 2001); I.R.C. §164. IRS Info. Ltr. 2018-0009, following IR 2017-120.

30. Restrictions On Using Ride Services Apply to IRS Agents. The Chief Counsel’s Office of the IRS has taken the positions that when an IRS agent uses third-party transportation for taxpayer’s appointments, an unauthorized disclosure of confidential return information under I.R.C. §6103 could be involved. The Chief Counsel noted that “return information” includes a taxpayer’s identity and whether the return was, is being, or will be, examined or subject to other investigation or processing in accordance with I.R.C. §6103(b)(2). The Chief Counsel’s Office noted that providing a taxpayer’s name and/or address to a third-party transportation provider, coupled with the agent’s job description and employing agency, could disclose that the taxpayer is under examination, criminal investigation or collection procedures, which constitutes

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confidential return information. The Chief Counsel’s Office concluded that third-party transportation is acceptable is the taxpayer’s identity is preserved perhaps by terminating the ride well before the taxpayer’s residence or if the driver does not know or cannot infer the reason for the ride. Prog. Mgr. Tech. Adv.2019-007.

31. Wind Energy Company Engaged in Sham Transaction. In early 2012, the plaintiff placed a qualified wind facility into service at a cost of $433,077,031. The plaintiff applied for a federal taxpayer grant (in lieu of tax credits) of $129,923,109. As part of the grant application, the plaintiff submitted a development agreement that claimed to show a “proof of payment” in support of a $60 million development fee. The plaintiff, a “project company,” paid the development fee to its parent company, Invenergy, LLC. The U.S. Treasury awarded the plaintiff a grant of $117,216,098. The Treasury explained that the reason for the $12.7 million shortfall was based on the plaintiff’s excessive cost basis in the facility based on the inclusion of the development fee in the cost basis calculation. The Treasury asserted that the development fee transaction was a sham lacking economic substance shaped solely by tax avoidance motives. The court agreed. Bank records showed that money passed through the bank accounts of several entities related to the plaintiff by wire transfer and then back into the original account. The court determined that the plaintiff could not establish any business purpose or economic substance to the banking transactions. A CPA from a national firm, as the result of an audit, testified that the development agreement contained no quantifiable services. Invenergy, LLC, was not able to produce any accounting journal entries showing a business purpose for the banking transactions. Thus, the court determined that the evidence showed a development fee with no quantifiable services, circular wire transfers that started and ended in the same bank account on the same day, none of which were corroborated by independent testimony. The court denied the plaintiff reimbursement of the $12,707,011 cash grant, and the U.S. Treasury was entitled to recover an overpayment of $4,380,039. Bishop Hill Energy, LLC, et al. v. United States, No. 14-251 C, 2019 U.S. Claims LEXIS 687 (Fed. Cl. Apr. 24, 2019).

IV. Credits

A. Research and experimental expenses.

1. Tinkering Isn’t Research. I.R.C. §174 provides a 20 percent credit for qualified research and experimental expenditures over a base period amount. But, the expenditures must be for research and development costs. That means they must be research and development expenses as those terms are construed in a laboratory sense that are incurred to discover processes and related information that would reduce/eliminate product uncertainty or development. Routine product testing expenses don't qualify. In addition, costs must be allocated with respect to a research activity between qualified expenses and those that are not qualified expenses, such as between salary (not eligible) and quality control testing (eligible). Four tests must be satisfied to claim the credit: the I.R.C. §174 test; a technological information test; a business component test; and a process of experimentation test. The taxpayer, upon the advice of a CPA firm, claimed the credit with respect to seven projects for the years at issue. However, the IRS claimed that the taxpayer had not proven that substantially all of the activities for which it claimed credits were a part of a process of experimentation. The Tax Court agreed. Thus, none of the projects constituted qualified research eligible for the 20 percent credit. Siemer Milling Co. v. Comr., T.C. Memo. 2019-37.

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B. Premium Assistance Tax Credit

1. Advance PATC Must Be Included In Income If Ineligibility Later Determined. The petitioners obtained government-mandated health insurance by participating in an Obamacare exchange. They paid monthly premiums for the insurance and elected to receive an advance premium assistance tax credit (PATC) based on their projected household income and their expected eligibility for the PATC under I.R.C. §36B. The advance PATC totaled $8,420 for the year in issue, reducing the monthly premium by over $700. They filed a joint return for 2014, the year in issue, reporting adjusted gross income of $97,061, but did not attach Form 8962 (for the PATC) to the return or reconcile their advance PATC with their eligibility for the PATC. The IRS disallowed the $8,420 PATC. The petitioners filed a petition with the Tax Court and filed a motion for summary judgment asserting that the insurance companies in the exchange committed malfeasance that negated the benefit of the premiums that they paid and that other taxpayers paid on their behalf. The Tax Court noted that the PATC is available to taxpayers with household income that doesn’t exceed 400 percent of the federal poverty line (FPL) based on household size. In addition, the taxpayer is to reconcile the receipt of advance PATC with their eligibility for the PATC when the return for the year is filed and if the advance PATC exceeds PATC eligibility, the taxpayer must report the difference as additional income tax. The Tax Court noted that the petitioners had income exceeding 400 percent of the FPL for a two-person household and, thus, were ineligible for the advance PATC. Thus, the petitioners’ tax liability was properly increased by the advance PATC. The statute, the Tax Court noted, makes no provision for equitable exceptions under state law. The Tax Court noted that if the petitioners wanted to pursue their malfeasance claim, they were free to do so elsewhere. Kerns v. Comr., T.C. Memo. 2019-14.

2. Excluded Social Security Must Be Included For Premium Assistance Tax Credit Computation. The petitioner elected to exclude a lump sum Social Security payment (which related to prior years) from gross income in 2014 under I.R.C. §86(e) and also excluded the amount from modified adjusted gross income (MAGI) for purposes of determining the premium assistance tax credit (PATC) under I.R.C. §36B. The IRS included the amount in MAGI for purposes of computing the PATC. The Tax Court agreed with the IRS. The court noted that the PATC can be taken in advance and then must be reconciled via Form 8962 at year-end to determine the actual PATC claimed on the return. The court noted that I.R.C. §36B(d)(2)(B) defines MAGI for purposes of the PATC and includes social security benefits that are not included in gross income via I.R.C. §86. The petitioner claimed that the amounts related to prior years should not be include in income for purposes of the PATC claimed on the 2014 return. The court held that because the taxpayer reported income on the cash basis, the year of receipt (2014) controlled the issue of inclusion in income of the social security benefits in accordance with Treas. Reg. §1.451-1(a). While the PATC code language of I.R.C. §36B is silent with respect to the effect on MAGI if an election is made under I.R.C. §86(e), the court held that I.R.C. §36B and the underlying regulations required that social security benefits received in a tax year that were not included in gross income under I.R.C. §86 for the tax year must be added to the taxpayer’s MAGI. As a result, the petitioner’s MAGI exceeded the threshold for PTC eligibility for 2014. Johnson v. Comr., 152 T.C. No. 6 (2019).

3. Bankruptcy Plan Payments Don’t Count For Purposes of PTC. The petitioners, a married couple, got their government mandated health insurance through an Obamacare state exchange. Their monthly premium was $716 monthly and an advanced premium assistance tax credit (PTC) of $609 per month for the 10 months of the 2014 tax year that they had health insurance coverage was paid directly to their

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insurer on their behalf. Also, during 2014 the petitioners made a monthly $25 payment in accordance with a Chapter 13 bankruptcy plan. On their 2014 return, the petitioners reported modified adjusted gross income of $86,312, but did not report any of the $6,090 of PTC that they received during the year. The IRS disallowed the $6,090 PTC. The agreed with the IRS, noting that I.R.C. §36B allows a PTC to a taxpayer with income between 100 percent and 400 percent of the federal poverty line. As applied to the petitioners’ household size, 400 percent of the federal poverty line was $78,120 for 2014. While their MAGI exceeded the 400 percent threshold, the petitioners claimed that their income should be reduced by their bankruptcy plan payments. The court noted that I.R.C. §36B does not provide for any reductions to AGI for any purpose. In any event, the reduction of their income by $300 would not reduce their income sufficiently to allow them to claim the PTC for 2014. Palafox v. Comr., T.C. Memo. 2018-124.

C. Miscellaneous

1. Taxpayer Can’t “Spin” Garbage” Into Tax Credits. The taxpayer was involved in the production and sales of landfill gas to a third party, which had entered into landfill license agreements with the owners and operators of 24 landfills primarily in Illinois, but also including ones in Ohio and Columbus, Kansas. The taxpayer claimed over $11 million in tax credits for producing fuel from a nonconventional source under I.R.C. §45K with respect to landfill gas asserted to have been produced from 23 landfills in 2005, 2006, and 2007. The taxpayer claimed the credits for one landfill for 2006 and 2007. The 24 landfills had varying degrees of equipment, monitoring, and production, from the nonexistent to the substantive, depending on the respective landfill and time- period in question. The levels of documentation of the gas rights, gas sales, and operation and maintenance agreements between the taxpayer and the third party varied, as did the documentation of actual landfill gas production and the documentation of expenses for which deductions were claimed. While the Tax Court determined that untreated landfill gas is a qualified fuel under I.R.C. §45K, and that the landfills at issue had the necessary equipment and were set-up properly to constitute a “qualified facility” under I.R.C. §45K(f)(1), the Tax Court disallowed the credits due to lack of substantiation of alleged production during the years at issue except as to one facility for the time period that the gas-to-electricity equipment was running at the facility. However, the Tax Court held that no tax credits were allowed for any period of time the landfills were engaged in “venting” or “flaring” because venting and flaring did not involve the production of a qualified fuel that was meant to produce energy that could be used by someone else. The Tax Court upheld the IRS imposition of an accuracy-related penalty. On further review, the appellate court affirmed. The appellate court noted that the “fuel” at issue was not qualified fuel used to produce energy but was simply released into the atmosphere. In addition, the appellate court noted the lack of credibility of the taxpayer’s records and that the taxpayer did not have rights to sell landfill gas at the landfills at issue. The taxpayer failed to produce any operation-and-maintenance agreements or documents that payments were actually made. The appellate court also held upheld the accuracy-related penalty. Green Gas Delaware Statutory Trust, Methane Bio, LLC, Tax Matters Partner, et al., v. Comr., No. 17-1025, 2018 U.S. App. LEXIS 22581 (D.C. Cir. Aug. 14, 2018), affn’g, 147 T.C. No. 1. (2016).

2. Determination of Wind “Farm” Basis Incorrect. At issue in this case was the appropriate method for determining the income tax basis in wind “farm” property for purposes of eligibility for grants under I.R.C. §1060. The U.S. Court of Federal Claims used a method that resulted in a value of nearly $207 million in cash grants in lieu of tax credits to the owners equal to 30 percent of the investment in development costs

135 associated with “specified energy property.” On further review, the appellate court determined that the lower court erroneously excluded the residual method of assessing cost basis as required by I.R.C. §1060. The appellate court determined that the transactions involved were “applicable asset acquisitions” under I.R.C. §1060. Accordingly, the appellate court remanded to the trial court for a determination of the proper allocation of the purchase prices to determined appropriately fair market value. The appellate court pointed out that the cost basis of purchased property must be divided among asset categories, with some being eligible to be counted toward the cash grants and some that are not, such as goodwill. Because that was not done, the unallocated method resulted in a much higher basis and much higher grant amount. The appellate court also determined that the trial court had improperly disallowed testimony of one of the government’s witnesses, a socialist and head of MIT’s MBA Program Finance Track. Alta Wind I Owner Lessor C v. United States, No. 2017-1410, 2018 U.S. App. LEXIS 20931 (Fed. Cir. Jul. 27, 2018).

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SESSION FOUR – 1:45-2:45 p.m. DEPRECIATION TOPICS

Depreciable Recovery Periods for Farm Assets

A. The following table is reproduced from IRS Publication 225, Farmer’s Tax Guide:

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B. Adjustments and additions to the IRS table include:

Race horses ≤ two years are seven-year assets [Rev. Proc. 87-56, Class 01.225].

The five-year status of farm equipment applies only to original use beginning with the taxpayer [Sec. 168(e)(3)(B)(vii)]. Used farm equipment remains at seven years.

The class life of residential rental property is 30 years for assets placed in service after 2017 [Sec. 168(g)(2)(C)(iv)].

C. Buildings and structures.

Farm real property appears in at least four classifications:

Class 00.3 land improvements (cost recovery period = 15 years);

Class 01.4 single purpose agriculture or horticulture structures (cost recovery period = 10 years);

Class 01.3 farm buildings (cost recovery period = 20 years); and

Sec. 1245 real property with no class life (cost recovery period = 7 years).

Commentary: The code generally restricts depreciable real estate to use of the straight-line 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 150% DB method.

Class 00.3 land improvements are items directly added to land, and may be Sec. 1245 or 1250 property, provided that they are depreciable.

Examples include sidewalks, roads, canals, waterways, wharves and docks, bridges, [nonfarm] fences, landscaping, shrubbery and transmission towers [Rev. Proc. 87-56].

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., 5 AFTR 2d 979, 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. 75- 137].

3) Expenses for maintaining such improvements should be deductible as repairs.

Based upon the description, land improvements do not look like buildings. Examples may include:

1) Silage bunkers;

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2) Concrete ditches, wasteways and pond outlets; and

3) Irrigation and livestock watering wells.

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 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.

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)].

Commentary: Only greenhouses and livestock structures qualify as single purpose ag and horticultural structures.

Assets which have the appearance of a building but qualify as Sec. 1245 assets (and not separately classified as single purpose ag or horticultural structures) are not buildings [Reg. 1.48-1(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)].

Structures such as storage facilities for potatoes, onions and other cold or controlled atmosphere storage facilities for fruits and vegetables are included in this category.

Commentary: Authorities defining property as qualifying for pre-1986 investment tax credit should be valid for determining property described in Sec. 1245(a)(3). 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. 1245 for depreciation recapture purposes.

If used for other purposes after the commodities have been removed, the structures are buildings, rather than Sec. 1245 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 84-5285, CA-9, 1984 and Bundy v. U.S., 59 AFTR 2d 87-682, DC-NE, 1986].

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 1970-296, 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 200013038].

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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.

In addition, dwellings provided rent-free to employees should also be 20-year farm buildings. This includes the house owned by a C corporation in which shareholder- employees are required to reside as a condition of their employment agreement.

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)].

By definition, this describes single purpose ag and horticultural structures [Sec. 1245(a)(3)(D)].

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)].

Grain storage in connection with a manufacturing and production activity qualifies for Sec. 179 [by way of Sec. 1245(a)(3)(B)(iii)].

D. Vineyard assets.

The Tax Court determined the proper class life or recovery period for several categories of depreciable vineyard assets [Trentadue v. Comm., 128 TC 8, 2007].

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).

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.

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.

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3) Conclusion: The drip irrigation system should be depreciated over the 7-year cost recovery period of the trellis. If the trellis is a machine, the 5-year cost recovery period should be available for new farm equipment.

E. Race horses.

The recovery period for a race horse depends on its age when placed in service.

A race horse no more than two years old at the time placed in service has a seven-year recovery period [Rev. Proc. 87-56, asset class 01.225].

A race horse more than two years old at the time placed in service has a three-year recovery period [Sec. 168(e)(3)(A)(i)].

Effective for horses placed in service after 2008 and prior to 2017, all race horses were assigned a three-year recovery period, regardless of age when placed in service [Sec. 168(e)(3)(A)].

F. 150% declining balance restriction.

Previous to 2018, assets used in a farming business were 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) [former Sec. 168(b)(2)(B)].

Commentary: Farm assets are no longer restricted to the 150% DB method.

G. Correcting accounting methods for fixed assets.

Background.

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].

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.

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. 1.1060-1(e)(1)(ii)]. However, the purchase of farm real estate alone does not represent a going concern business; Form 8594 is not required.

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.

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Effecting an accounting method change.

An accounting method change may only be made with the consent of the IRS [Sec. 446(e); Reg. 1.446-1(e)(2)].

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.

Accounting method changes resulting in an increase to income are spread equally over a four-year period beginning in the year of change. Net negative adjustments are claimed in full in the year of change [Rev. Proc. 2015-13, Sec. 7.03].

Accounting method changes are not bound by the statute of limitations [Rev. Proc. 2015-13, Sec. 2.06(1)].

Planning opportunity.

Some taxpayers may have aggressively allocated purchase prices. Unsupported allocations of purchase prices to depreciable/amortizable assets such as residual fertilizer value, claiming amortization of excess value attributable to government payments or excess values to depreciable assets such as drainage systems are easy targets for government revenue agents.

On the other hand, improper allocations of purchases years ago may have failed to allocate 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.

Automatic changes in accounting method may cure problem allocations, under-depreciation and over-depreciation from prior years. The change from impermissible depreciation and amortizable is DCN 7 [Rev. Proc. 2018-31, 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 3115.

Farmers and the Sec. 179 Deduction

A. Background.

Taxpayers may elect to expense up to $1 million (indexed) of 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 [Sec. 179].

Sec. 179 property is defined as:

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1) Tangible property acquired for use in a trade or business and certain computer software;

2) Which is Sec. 1245 property (as described in Sec. 1245(a)(3)); and

3) Which is acquired by purchase for use in the active conduct of a trade or business.

Sec. 1245(a)(3) property includes (among others):

1) Tangible personal property;

2) Other property (not including a building or its structural components) used as an 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

3) A single purpose agricultural structure or horticultural structure.

Taxpayers making the Sec. 179 expensing election must reduce the property’s depreciable basis by the amount of the expense deduction and then depreciate any remaining basis.

This deduction phases out on a dollar-for-dollar basis to the extent the taxpayer’s eligible purchases exceeds $2.50 million (indexed).

The indexed amount for 2019 is $1.02 million.

Single purpose structures.

A single purpose agricultural structure is an enclosure or structure designed, constructed and used for the housing, raising and feeding a particular type of livestock and their produce, and for housing the equipment for that use.

A single purpose horticultural structure is a greenhouse designed, constructed and used for the commercial production of plants or a structure designed, constructed and used for the commercial production of mushrooms [Sec. 168(i)(13)].

Practice Tip: Farm buildings that are not single purpose structures and not an integral part of the manufacturing, growing or production process are not eligible for Sec. 179. Be careful when adding farm buildings to depreciation schedules. Because farm buildings are 20-year property, computer depreciation software may default to treating farm buildings as eligible for Sec. 179. However, if this building contains new improvements to the internal structure, those improvements will qualify for Section 179 even though it is 20-year property.

B. Extended election and revocation period for Sec. 179.

Taxpayers may revoke the Sec. 179 election on an amended return. Such revocation, once made, is irrevocable [Sec. 179(c)(2)].

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Example 1 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 2019, he recognizes that the S corporation has made a Sec. 179 election with respect to $600,000 of farm equipment (Joe is allocated a $300,000 Sec. 179 deduction as a 50% shareholder). However, during 2019, Joe made well and drainage facility improvements of approximately $800,000. 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 $440,000, so that his 50% is no more than $220,000.

IRS regulations allowing late or amended Sec. 179 elections.

A late Sec. 179 election may be made on an amended return at any time within the statute of limitations [Reg. 1.179-5(c)].

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. 2008-54, Sec. 7].

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. 1.179-5(a)].

Example 2 Amended return to elect additional Sec. 179 deduction

Tom, a farm proprietor, purchased and placed in service one item of Sec. 179 property during 2017, a tractor costing $135,000. On Tom’s 2017 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 2017 base year had lower taxable income. Accordingly, an amended return is prepared for 2017, 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 2017.

Commentary: Following are examples of where an amended Sec. 179 election could be helpful:

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.

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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).

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.

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. This might be applicable if insufficient assets were acquired in the year under preparation or the taxpayer is otherwise looking to reduce taxable income.

Practice Tip: When amending Sec. 179 elections, confirm the treatment of the asset under bonus depreciation. Bonus depreciation of 100% of the cost basis, claimed after the Sec. 179 deduction, must be recomputed unless the election out was made on the original return for that class of asset. If the election out of bonus depreciation was not made, amending the prior year Sec. 179 election may be ineffective.

Example 3 Amended return to shift Sec. 179 deduction

Tim, an ag producer, purchased and placed in service two items of Sec. 179 property in 2018: a tractor costing $300,000 and a combine costing $310,000. In his 2018 Form 1040, Tim elected to expense all of the $300,000 tractor. He also elected out of bonus depreciation to claim regular depreciation on the combine.

In November 2019, Tim decided he no longer needed the tractor and sells that asset for $220,000. Under the regulations, Tim is allowed to file an amended return for 2018, revoking the Sec. 179 election for the tractor, claiming normal depreciation for 2018 on that asset, and making an election under Sec. 179 to claim the $300,000 amount on the combine. The amended return must also include an adjustment to the depreciation previously claimed on the combine [Reg. 1.179-5(c)(4), Example 1]. As a result of the amended Sec. 179 election, Tim has eliminated over $160,000 of gain that would have occurred from the sale of the tractor.

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.

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.

Sec. 179 for certain trucks and sport utility vehicles (SUV) is limited to $25,000 [Sec. 179(b)(6)].

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The provision applies to SUVs and trucks rated between 6,000 pounds and 14,000 pounds gross vehicle weight.

While the legislation refers to an 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.

The statute excludes three categories of vehicles from the $25,000 limit on the Sec. 179 deduction:

Any vehicle designed to have a seating capacity of more than nine persons behind the driver’s seat (e.g., a hotel shuttle van);

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

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 4 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 $40,000. This vehicle has a gross vehicle weight rating over 6,000 pounds. Ted may claim a Sec. 179 deduction of up to $25,000, and the remaining adjusted basis is eligible for normal depreciation under the general rules.

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.

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Example 5 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 $55,000. 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. 179.

If Fred uses the 75% safe harbor for farm vehicles, the available amounts are reduced by 25%.

D. Noncorporate-lessor rules.

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:

The term of the lease is less than 50% of the class life of the property; and

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.

Commentary: Delaying the rental income payment will not effectively reduce the amount of rent produced by the property.

The noncorporate lessor rules present a significant barrier to farm landlords, whether cash rent or crop share, with respect to many real estate improvements.

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 2010-241].

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. The 15% test may be met by adjusting the terms of the lease.

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Example 6 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. Because 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. 87-56], Lou is allowed to claim the Sec. 179 deduction against his rental income.

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. 1.46-4(d)(3)].

S corporations are corporations and therefore not subject to the noncorporate lessor rules [PL 101- 508 amending Sec. 179(d)(5)].

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.

The Sec. 179 deduction cannot exceed aggregate business taxable income [Sec. 179(b)(3)].

Aggregate business net income must be derived from businesses actively conducted during the taxable year. This definition includes Sec. 1231 gains or losses, as well as interest from the working capital of the business [Reg. 1.179-2(c)].

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. 1.179-2(c)(6)(ii)].

Wages and salaries received by a taxpayer as an employee are included in the aggregate amount of active business taxable income of the taxpayer.

In addition to applying at the individual taxpayer level, this limitation also applies to pass- through 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

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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. 1.179-2(c)(6)(ii)].

The limitation for an S corporation is determined by increasing business net income for those deductions claimed for compensation to shareholder-employees [Reg. 1.179-2(c)(3)(ii)].

Similarly, the taxable income limitation for partnerships is determined after adding back deductions for guaranteed payments paid to partners [Reg. 1.179-2(c)(2)(iv)].

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)].

Example 7 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. 1.179-2(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.

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F. Sec. 179 annual dollar limitation applicable to partnerships.

The annual dollar limitation applies to partnerships and S corporations as well as to each individual owner [Reg. 1.179-2(b)(3)(i)].

Practice Tip: 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 trade or business (requiring a partnership income tax return), a single Sec. 179 limitation would apply to equipment purchases. Conversely, if the co-ownership does not represent a partnership, each individual would be entitled to use their respective share of equipment purchases in calculating the Sec. 179 limitation. The choice of business versus nonbusiness treatment will affect the qualification of the activity for Sec. 199A.

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” (2018 instructions, page 3). The absence of a formal written partnership agreement is not controlling. Rather, the degree of business activity conducted by the co-owners is determinative [Cusik v. Comm., TC Memo 1998-286].

G. No Sec. 179 deduction for estates or trusts.

An estate or trust may not claim a Sec. 179 deduction [Sec. 179(d)(4)].

Example 8 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. Through 2022, however, 100% bonus depreciation may be available to the trust.

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. 1.179-1(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.

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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.

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. 1.179-1(f)(3).

Example 9 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 Sec. 179.

The IRS previously ruled that vineyards and other fruit-bearing trees were not Sec. 179 property [Rev. Rul. 67-51]. However, this ruling was issued when the definition of eligible Sec. 179 property excluded land improvements and also did not refer to Sec. 1245 status.

The current definition of Sec. 179 property requires that the property is:

Tangible property subject to Sec. 168 cost recovery;

Sec. 1245 property; and

Acquired by purchase for use in an active trade or business [Sec. 179(d)(1)].

A taxpayer placing a vineyard in service may claim the Sec. 179 deduction for its costs [CCA 201234024].

This ruling determined that a vineyard is other tangible property described in Sec. 1245(a)(3)(B)(i), and accordingly is eligible for the Sec. 179 deduction.

The ruling also noted that a vineyard whose costs included labor and other capitalized Sec. 263A planting costs represented property acquired by purchase for Sec. 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)].

Caution: The inclusion of orchard and vineyards as qualifying for Sec. 179 may cause the taxpayer to exceed the asset acquisition limit ($2.5 million, indexed), denying Sec. 179 for any

151 assets placed in service during the year. Bonus depreciation is available unless the taxpayer was required to use ADS for depreciation.

Commentary: A Chief Counsel Advice is lower level authority than a Revenue Ruling. Rev. Rul. 67-51 has been out of date for over 30 years and, although the CCA states that Rev. Rul. 67-51 “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.

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Sec. 179 Eligibility Checklist

With the increased importance of the Sec. 179 deduction (currently $1 million, indexed for inflation), the following Eligibility Checklist can serve as a quick reference. Although the Sec. 179 deduction is available for qualified improvement property, it is unlikely that agricultural property will fit this definition, except (perhaps) internal improvements to a general use farm building.

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. 1.179-5(c); Rev. Proc. 2008-54].

Asset Addition Phase-out Limit

 Sec. 179 deduction phases out dollar-for-dollar as eligible asset purchases exceed $2.5 million (indexed for inflation).  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. 1231 gains and losses, Sec. 1245 and 1250 depreciation recapture income, interest income from working capital of a business and wage income [Reg. 1.179-2(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. 1245 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.

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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. 1.179-1(f)(3)].  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.

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. 1563 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. 1.179-2(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. 1.1563-1(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.)

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Farmers and 100% Bonus Depreciation

A. Background.

The 100% bonus depreciation deduction and the Sec. 179 deduction amount can both apply for a taxpayer. The 100% bonus depreciation deduction is generally available for the cost of assets not written off with the increased Sec. 179 deduction.

B. Summary of bonus depreciation rules: * Acquired & Placed in Service Bonus Depreciation % Long-Lived % After 9/27/2017 100% 100% 2023 80% 100% 2024 60% 80% 2025 40% 60% 2026 20% 40% 2027 0% 20% Acquired < 9/28/2017, Placed in Service Bonus Depreciation % Long-Lived % 9/28/2017 to 12/31/2017 50% 50% 2018 40% 50% 2019 30% 40% 2020 0% 30%

* Includes plants bearing fruits and nuts

C. Planning opportunities.

General purpose farm buildings, such as machine sheds and shops, are 20-year assets and accordingly qualify for the bonus provision if constructed and placed in service by year-end.

In the authors’ view, a farm residence within a C corporation is also a 20-year asset that qualifies for bonus depreciation.

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.

If a new asset is acquired by trade, both the boot and any adjusted tax basis of the relinquished asset qualify for the 100% bonus [Reg. 1.168(k)-1(f)(5)(iii)].

The bonus depreciation provision electively can be declined by a taxpayer. Election out is made by asset class (defined as cost recovery period, e.g. for all 3 year assets, for all 5 year assets, etc.) [Sec. 168(k)(2)(D)(iii)].

The taxpayer has greater flexibility to hit a target taxable income by using Sec. 179.

The Sec. 179 deduction may be amended; the bonus depreciation is irrevocable unless IRS permission is obtained.

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Depreciation recapture and bonus depreciation upon sale.

All depreciation expense associated with Sec. 1245 assets is subject to recapture as ordinary income [Sec. 1245(a)(1)].

Bonus depreciation is allowed on certain real property assets, such as machine sheds and shops [Sec. 168(k)(2)(A)(i)(I), Rev. Proc. 87-56, class 01.3 farm buildings]. This property is described in Sec. 1250 in that it is real property that is not Sec. 1245 property [Sec. 1250(c)].

Additional depreciation on Sec. 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)].

Bonus depreciation is not considered a straight-line method [Reg. 1.168(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.

Commentary: If the building has been held for over 20 years after being placed in service, Sec. 1250 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 [Sec. 1(h)(1)(D) and (E)].

Recapture of Sec. 179 and bonus depreciation: Conversion to personal use.

If a Sec. 179 deduction was claimed with respect to business property and that property is no longer predominantly used in business, the benefit of the Sec. 179 deduction must be recaptured [Sec. 179(d)(10); Reg. 1.179-3(f)(2)].

Property is not predominantly in a business use if 50% or more of its use is not business use [Reg. 1.179-1(e)(2)].

However, in measuring the recapture income from a conversion to personal or investment use, the taxpayer is allowed to reduce recapture income by the amount of depreciation that would have occurred under Sec. 168 if the Sec. 179 deduction had not been claimed [Reg. 1.179-1(e)(5)].

The regulations confirm that conversion to personal use after claiming bonus depreciation does not cause a redetermination or recapture of the bonus amount [Reg. 1.168(k)- 1(f)(6)(iv)].

Commentary: If a taxpayer faces Sec.179 recapture because of conversion of an asset from business to personal use, the tax practitioner should examine the eligibility of the asset for bonus depreciation.

1) Unless the taxpayer elected out of bonus depreciation, the removal of Sec. 179 leaves bonus depreciation plus regular depreciation in its place. The recapture income is the difference.

2) Bonus depreciation is regular depreciation that minimizes or possibly eliminates the amount of Sec. 179 recapture.

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3) Different rules apply for listed property. Bonus depreciation and Sec. 179 are both recaptured if listed property use no longer exceeds 50% [Sec. 280F(b)(2)].

Sec. 179 recapture income from conversion to personal use is reported on Schedule C, E or F (i.e., where the deduction was originally claimed). The income is subject to self- employment tax [Instructions for Form 4797, Part IV].

Example 1 Minimizing Sec. 179 recapture upon conversion to personal use

John purchased a new tractor in 2018 for $100,000 and claimed a Sec. 179 deduction to fully expense its cost. In 2022, John retires from farming, but retains the tractor for personal use. Under normal Sec. 179 recapture rules, John would have been entitled to retain about 4/5ths 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 purchased in 2018, 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 Sec. 179 recapture is required.

Commentary: State income tax conformity needs to be considered (i.e., has the applicable state adopted the 100% bonus or expanded Sec. 179 deduction?).

Depreciation summary. The following is a quick recap of key differences between the expanded Sec. 179 deduction and bonus depreciation:

Sec. 179 Bonus

New vs. used Both Both

Trades Boot only Entire basis

Effective for Maximum based upon tax year 100%

$1 million, indexed Phases down after 2022

Eligible assets Sec. 1245 property Recovery period of ≤ 20 years (i.e., all farm depreciable assets)

Phase-out Yes, when qualifying property > No $2.5 million (indexed)

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Repair Regulations

A. Background.

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 or acquired for resale [Reg. 1.263(a)-2(d)].

A taxpayer must capitalize amounts paid to improve a unit of property owned by the taxpayer. 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 [Reg. 1.263(a)-3(d)].

However, the regulations provide a de minimis safe harbor elective exception to the general requirement to capitalize amounts [Reg. 1.263(a)-1(f)(1)].

B. De minimis safe harbor election.

Amounts paid to acquire or produce tangible property, not exceeding a dollar threshold, may be deducted under the de minimis safe harbor.

To be eligible, however, a taxpayer must:

Have an applicable financial statement (AFS);

Have at the beginning of the taxable year written accounting procedures treating as an expense for non-tax purposes amounts paid for property:

1) Costing less than a specified dollar amount, or

2) With an economic useful life of 12 months or less;

Treat the amounts paid during the taxable year as an expense on its AFS in accordance with its written accounting procedures; and

The amount paid for the property does not exceed $5,000 per invoice or per item as substantiated by the invoice [Reg. 1.263(a)-1(f)(1)(i)].

An applicable financial statement (AFS) is defined as:

A financial statement filed with the Securities and Exchange Commission (the 10-K or the Annual Statement to Shareholders);

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

A financial statement required to be provided to the federal or a state government or any federal or state agencies [Reg. 1.263(a)-1(f)(4)].

Taxpayers without an AFS can also utilize the de minimis safe harbor except that the maximum amount paid for the property is reduced to $2,500 per invoice or item instead of $5,000. Also, there is no written policy requirement, but the de minimis amounts must be treated as an expense

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on the taxpayer’s books from the beginning of the year [Reg. 1.263(a)-1(f)(1)(ii); IRS Notice 2015-82].

To determine whether the de minimis threshold is exceeded, 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. However, those costs are not required to be included if they are not included on the same invoice [Reg. 1.263(a)-1(f)(3)(i)].

The regulations specifically prohibit the use of the de minimis safe harbor election for property that is held as inventory for resale [Reg. 1.263(a)-1(f)(2)(i)].

Election. A taxpayer makes the de minimis safe harbor election annually by attaching a statement to its timely filed federal tax return.

The election must apply to all amounts paid during the year for property meeting the requirements discussed above (e.g., a taxpayer cannot use different de minimis limits for different types of property) [Reg. 1.263(a)-1(f)(5)].

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. 1.263(a)-1(f)(5)].

Property sold which has been expensed under the de minimis safe harbor is not treated as a capital asset under Sec. 1221 or as property used in a trade or business under Sec. 1231 (i.e., it is reported as ordinary income) [Reg. 1.263(a)-1(f)(3)(iii)].

For self-employment tax (SE tax) purposes, gain or loss is excluded if it is from the sale, exchange, involuntary conversion or other disposition of property if the property is neither inventory or property held primarily for sale to customers [Sec. 1402(a)(3)(C)]. The regulations supporting this exclusion from SE tax state that it is immaterial whether a gain or loss is treated as a capital gain or loss or as an ordinary gain or loss [Reg. 1.1402(a)-6(a)].

Commentary: The sale of any assets that were expensed under the de minimis safe harbor should be reported as ordinary income on Form 4797, Part II. This conclusion is based on the authorities in the two prior paragraphs, holding that:

Disposition of property subject to de minimis expensing results entirely in ordinary income.

This ordinary income is not subject to SE tax.

C. Elective capitalization of repairs.

Taxpayers may elect to capitalize otherwise deductible repairs [Reg. 1.263(a)-3(n)].

The election applies to all amounts paid for repair and maintenance to tangible property that it treats as capital expenditures on its books and records in that taxable year.

Any amount for which the election is made is not treated as an amount paid for repair or maintenance.

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Commentary: In a low income year, in addition to electing out of bonus depreciation (Topic 4C) and choosing not to elect Sec. 179 expensing (Topic 4B), taxpayers incurring otherwise deductible repairs may choose to capitalize and depreciate. The election is made for those specific repair amounts, but once chosen, books and records must follow the same capitalization elected for tax. If a financial statement is prepared, the financial statements must reflect capitalization. Depreciation expense should be computed using depreciation methods applicable for the financial statement.

The election to capitalize is made with a statement attached to the return reflecting those repairs that have been capitalized. These are limited to amounts that aren’t otherwise required to be capitalized under the repair regulations [Reg. 1.263(a)-3(n)(2)].

The election is made at the entity level (S corporation or partnership) rather than by the individual owner.

The election is made on the original return filed for the year. The taxpayer may elect to capitalize on an amended return only upon receipt of permission from the IRS by letter ruling request.

A sample election statement follows. The election statement does not require a signature.

Section 1.263(a)-3(n) Election

Joe Farmer

320 Any Street

Any Town, MN 00000

EIN 12-3456789

Taxpayer elects to capitalize the following repair and maintenance costs under Reg. 1.263(a)-3(n):

Repairs to 350 hp tractor $ 15,235

Repairs to engine of combine 7,598

Overhaul of swather 6,952

Total $ 29,785

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Section 263A Inventory Capitalization and Farmers

A. Background.

Sec. 263A requires the capitalization of preproductive costs. The costs incurred to grow crops with a preproductive period of more than two years must be capitalized [Sec. 263A(d)(1)(A)(ii)].

Taxpayers meeting the gross receipts test (i.e., average annual gross receipts, aggregated with related parties) and not a tax shelter are not required to capitalize preproductive costs [Sec. 263A(i)].

The IRS has published a list of crops which it has determined have preproductive periods subject to Sec. 263A. The list includes almonds, apples, apricots, avocados, blueberries, cherries, chestnuts, coffee beans, currants, dates, figs, grapefruit, grapes, guavas, kiwifruit, kumquats, lemons, limes, macadamia nuts, mangoes, nectarines, olives, oranges, peaches, pears, pecans, persimmons, pistachio nuts, plums, pomegranates, prunes, tangelos, tangerines, tangors, and walnuts [IRS Notice 2000-45].

This list is based upon nationwide preproductive periods, measured from first planting to first harvest, and not the taxpayer’s experience.

The rules apply even though the taxpayer’s experience reflects a less than two-year period.

The rules apply even though the taxpayer acquires land with growing crop midway into its preproductive period, such that less than two years remain until the first marketable harvest.

Example 1 Determining pre-productive period

Alan, who fails the gross receipts test, acquires blueberry plants from Spring Water Nursery. Alan plants the blueberries in the fall of Year 1. In Alan’s experience, he has a marketable crop in July of Year 3, which is less than two years from his date of planting.

Alan is required to capitalize all of his costs in growing the blueberries to production. The IRS has determined that blueberries have a nationwide pre-productive period of two years.

Variation: Alan purchases a blueberry field from his neighbor, Bill, in August of Year 2. Alan will harvest the first yield from the blueberries in July, Year 3. Because there is less than two years remaining in the pre-productive period, may Alan deduct the costs of raising the blueberries to harvest?

No. Blueberries have a pre-productive period of more than two years. Consequently, costs incurred by each taxpayer in the pre-productive period are required to be capitalized, including the costs of the nursery which has no intent of raising the blueberries to production. Costs incurred may include labor costs in planting, trimming, training, etc., fertilizer, chemicals, irrigation, depreciation on the trellis, depreciation on other farm assets used during the pre-productive period, overhead factors, etc.

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Blackberries, raspberries and papayas were removed from the list [IRS Notice 2013-18].

For taxpayers who previously capitalized growing costs for these plants, not applying Sec. 263A requires a change in method of accounting [Rev. Proc. 2013-20, Sec. 2.06].

An automatic accounting method change procedure is available.

1) In addition to allowing a method change for taxpayers previously capitalizing pre- productive costs of these plants, the procedure also allows those who avoided capitalization (by making an election to use ADS depreciation) to adopt general depreciation methods. The revocation otherwise requires advance consent. See E. below.

2) As a net negative amount, the adjustment is taken into account in the year of change [Rev. Proc. 2015-13, Sec. 7.03(1).

3) The designated automatic accounting method change number is 181.

B. Determining pre-productive costs.

Actual costs must be capitalized.

The IRS has noted that studies performed by universities as to the development costs of crops may provide guidance to the revenue agent for determining the reasonableness of the taxpayer’s Sec. 263A computation [MSSP Training Guide, Chapters 4 and 6].

The election under Sec. 179 provides an expense that is not subject to Sec. 263A capitalization [Reg. 1.263A-4(d)(4)(ii)].

Commentary: Sec. 179 is available for depreciable assets placed in service during the year. Depreciation on an irrigation system or trellis, including bonus depreciation, is otherwise capitalized under Sec. 263A. Electing Sec. 179 on these assets removes the depreciation expense from capitalization.

C. Previously capitalized costs.

Post-2017, the requirement to apply Sec. 263A is removed if the gross receipts test is met (and the taxpayer is not a tax shelter) [Sec. 263A(i)]. The exception benefits manufacturers, resellers previously subject to Sec. 263A, those who self-construct property, farmers who grow crops with preproductive periods in excess of two years, and taxpayers who construct long-lived property.

Any change in method of accounting made pursuant to this rule is made under the automatic consent procedures and made with a full Sec. 481(a) adjustment [Sec. 263A(i)(3)].

The designated automatic accounting method change number is 234.

The 5-year rule does not apply if the change is made in one of taxpayer’s first three tax years beginning after December 31, 2017.

A change in method to be exempt from Sec. 263A can be filed on the same Form 3115 as a change to be exempt from Sec. 471 or an accrual to cash change [Rev. Proc. 2018-31, sec. 12.16 as modified by Rev. Proc. 2018-40].

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The exemption from the UNICAP rules under this provision is available for tax years beginning after December 31, 2017. The change in accounting method applies for current and future costs and also effectively expenses the remaining net book value of previously capitalized costs [Rev. Proc. 2018-40, Sec. 3.02(3), confirmed by telephone call with IRS National Office, 1/30/2019].

Example 2 Accounting method change for preproductive costs

FACTS:  A & M, a vineyard/orchardist, has developed its vineyards and orchards over several years.  Aggregated average annual gross receipts are not greater than $25 million.  The depreciation schedule includes the following assets:

2009 Grapes 2014 Apples 2016 Pears Cost$ 1,800,000 $ 1,000,000 $ 900,000 Accumulated depreciation (1,530,000) (350,000) (135,000) Net book value, 12/31/2017$ 270,000 $ 650,000 $ 765,000

Remaining net book value, total$ 1,685,000

RESULT:  Upon filing Form 3115 for 2018, A & M may deduct the remaining net book value of previously capitalized orchards and vineyards.  As a net negative adjustment, the expense is claimed in the year of change (2018).  A & M may not spread the adjustment over a number of years.

Taxpayers changing accounting methods to conform to opportunities available due to the TCJA are provided reduced filing requirements for Form 3115, Application for Change in Accounting Method [Rev. Proc. 2018-40, modifying Rev. Proc. 2018-31 to add Sec. 12.16].

D. The 263A(d)(3) election to deduct pre-productive costs.

The election to avoid capitalization of pre-productive costs requires all farm assets to be depreciated using ADS.

The ADS method requires straight-line depreciation over the class life (not to be confused with recovery period) of the property.

All farm assets acquired subsequent to the election are subject to the ADS rules.

The Sec. 263A(d)(3) election must be made for the first year in which costs subject to the capitalization rules apply.

The election may be appropriate for beginning farmers who otherwise have limited income to offset with farm deductions, or farmers who are not expected to require intensive investment in depreciable assets. Each farmer’s facts and circumstances must be analyzed to determine if the election is appropriate.

Livestock farmers or farmers with relatively small investments in crops subject to the pre- productive rules might not desire the election, so that MACRS can continue to be used on all farm assets.

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Commentary: The election should be considered only by taxpayers that fail the gross receipts test.

The election may be made with IRS consent in a year subsequent to the first year in which capitalizable costs were incurred. Form 3115 is required, filing as a nonautomatic change requiring advance IRS consent and user fees [Reg. 1.263A-4(d)(3)(ii)].

Once the election is made, IRS permission is required to revoke (see E. following).

If the Sec. 263A(d)(3) election is made, the taxpayer is required to use ADS depreciation [Sec. 263A(e)(2)]. Bonus depreciation is not available [Sec. 168(k)(2)(D)].

E. Procedure to revoke Sec. 263A(d)(3) election.

No revenue procedure or other guidance from the IRS has been issued instructing taxpayers on how to revoke the Sec. 263A(d)(3) election.

A private letter ruling request in the form of Form 3115 is necessary. This is not an automatic change and must be filed within the taxable year of the change.

Prepaid Farm Expenses

A. Background.

A cash method farmer is allowed to deduct expenses paid during the year. However, three limitations can affect the ability to deduct prepaid expenses.

Three tests must be satisfied to deduct prepaid farm expenses [Rev. Rul. 79-229].

Prepaid farm expenses may not exceed 50% of non-prepaid farm expenses [Sec. 464(d)].

In the case of any farming syndicate, deductions for expenses are only allowed for the year in which the items are actually used or consumed.

B. General prepaid expense rules.

The IRS identified three tests that must be met for a prepaid expense to be currently deductible. Although this ruling uses prepaid livestock feed as its focus, it is considered to have application to any prepaid supply item [Rev. Rul. 79-229].

Test 1: The expenditure must be an actual purchase; it cannot be a mere deposit to buy in the future.

In distinguishing between a prepayment and a deposit, the ruling suggests four factors that would show a deposit rather than a purchase. These factors are:

1) Absence of a specific quantity of items purchased;

2) A right to a refund of any credit that remains;

3) Treatment of the expenditures as a deposit on the seller’s book; and

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4) A right to substitute other goods or services for those specified in the purchase contract.

The authors are of the opinion that the treatment on the seller’s books as a deposit should have no bearing on the determination of the expenditure being a deposit or prepayment.

1) The farmer has no control over the seller’s accounting methods.

2) Seller treatment as a deposit may be allowed due to Reg. 1.451-5(c).

3) The farmer’s deductibility should not depend on the seller following correct accounting methods.

In addition, the authors are of the opinion committing to a minimum quantity (rather than a specific quantity) of items should suffice, as long as the amount paid does not exceed the minimum quantity specified.

Likewise, the payment towards a price and quantity not in excess of the contracted amount should be viewed as a prepayment, rather than a deposit.

Example 1 Prepayment toward commitment

Aaron, a hog finisher, views the current price of corn as an opportunity to lock in his year’s supply. He requires 150,000 bushels for feed until the next harvest. After meeting for tax planning in December, he determines that a prepayment of $200,000 will result in his taxable income hitting his targeted taxable income. Aaron agrees to purchase 150,000 bushels, to be delivered between January and September as needed, and purchases $200,000 at December 31 for later delivery. This payment is not a deposit on a future purchase, but rather is a payment on a specific current purchase, generating a deductible expense.

Variation: Aaron wants to protect against the possibility that the corn price may drop. He and his supplier agree that Aaron’s final price will be the average of the quoted price nearest the 15th of the month for the months of January through September, not to exceed $7.00 per bushel and not less than $3.00 per bushel; Aaron commits to 150,000 bushels. Because the $200,000 payment on December 31 does not exceed the minimum price of the contract of $450,000, Aaron has a deductible expense at the date of payment.

Practice Pointer: A cash method farmer should secure an invoice that clearly specifies a definite quantity, quality, and price for the items purchased. There should be no right to a refund or repurchase noted on the invoice.

Test 2: The expenditure must be made for a business purpose and not merely to avoid taxes.

As a general rule, farmers normally can establish their prepaid acquisition of supply items is for legitimate business purposes.

Examples of business reasons for early purchase have included securing adequate quantities, discounts for early purchase, and expectations of rising costs [Van Raden v. Comm., 71 TC 1083, aff’d. 48 AFTR 2d 81-5607, CA-9, 1981].

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Test 3: The expenditure must not result in a material distortion of income [Rev. Rul. 79-229].

The ruling lists the following factors for determining whether the deduction resulted in a material distortion of income:

1) The relationship between quantity purchased and the projected quantity to be used in the next year;

2) Materiality of the expenditure in relation to total income of the taxpayer for the year;

3) Customary business practices of the taxpayer in buying supplies and the business purpose for paying in advance;

4) The relationship between the expenditure and past purchases;

5) The time of year in which the expenditure was made; and

6) How deductions of prepaid expenditures have affected taxes paid by the farmer in previous years.

Commentary: This material distortion of income test should not present a barrier if the taxpayer prepays an expenditure that does not produce a benefit extending beyond 12 months. The so-called repair regulations contain a definition of currently deductible materials and supplies that includes property reasonably expected to be consumed within 12 months [Reg. 1.162-3(c)(1)(iii)].

C. 50% prepaid expense limit.

To the extent prepaid farm supplies of a farmer using the cash method of accounting exceed 50% of the deductible non-prepaid farm expenses for the taxable year, the prepaid expenses are only deductible as the purchased items are consumed [Sec. 464(d)].

For purposes of the 50% test, deductible non-prepaid farm expenses include ordinary and necessary operating expenses of the farm, interest and taxes paid and depreciation on farm assets.

Costs that must be inventoried or capitalized are not included in the 50% test.

Prepaid rent is not a prepaid farm supply [Sec. 464(d)(3)(B) referring to subsections (a) and (b)].

There are two exceptions to the 50% rule that allow prepaid expenses to be deducted in full:

An eligible farmer who fails to satisfy the 50% test due to a change in business operations directly attributable to extraordinary circumstances, including government crop diversion programs; and

An eligible farmer who satisfied the 50% test on the basis of the three preceding taxable years. The three-year test is computed on an aggregate basis.

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Example 2 Calculating the 50% prepaid farm supplies limit

Joe has total farm expenses, including depreciation, on his current Schedule F of $1,000,000. $600,000 of these expenses are deductible non-prepaid items for the year, with the remaining $400,000 representing prepaid feed, chemicals and fertilizer purchases at year-end. The deduction for the prepaid supplies is limited to $300,000 (i.e., 50% of $600,000). The remaining $100,000 carries over as a deduction in the next year, no longer a prepaid farm supply (presumably, consumed).

D. Farm syndicate rules.

In the case of any farming syndicate, deductions for feed, seed, fertilizer or similar farm supplies are only allowed for the tax year in which the supplies are actually used or consumed. Similarly, the costs of purchased productive poultry must be capitalized and deducted ratably over the lesser of 12 months or their useful life, while poultry purchased for resale may only be deducted in the year sold [Sec. 464].

E. The Peterson Hatchery case.

An Eighth Circuit case took a surprisingly harsh view of a year-end prepaid feed expense claimed by a cash method S corporation operating a turkey hatchery. The Appellate Court, in affirming an unreported District Court decision, held that the S corporation had not met the prepaid feed tests of Rev. Rul. 79-229, and accordingly disallowed prepaid expenses [R.A. Peterson, 87 AFTR 2d 2001-2323, CA-8, 5/24/01].

The year-end prepayment of feed represented only about 17% of the annual feed expenditures of the business. There were only very nominal discounts involved with these feed prepayments, and apparently the business purpose test was an issue.

The taxpayer’s attorney argued that Rev. Rul. 79-229 was not relevant because of the subsequent enactment of the 50% statutory limit of Sec. 464(d).

Eighth Circuit opinion.

The court determined that Sec. 464(d) simply provided an outer limit of 50% on the amount of prepaid expenses that were currently deductible. In the court’s view, this statute did not eliminate the long-standing underlying requirements of Rev. Rul. 79-229 that cash method prepaid expenses must be actual purchases, have a business purpose, and not result in a material distortion of income.

Commentary: The focus of the Eighth Circuit on the argument of the interplay of the 50% limit and Rev. Rul. 79-229 apparently moved the Eighth Circuit away from the more important issue of whether the turkey operation had a legitimate business purpose for the prepayment. Normally, examples of business purpose benefit for prepaid expenses include fixing maximum prices, securing an assured feed supply, or securing preferential treatment in anticipation of a possible shortage. At a minimum, this case stands for the importance of reminding clients of the need to be able to justify a business purpose for each prepaid expenditure.

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F. Prepaid rent clarification.

In general, taxpayers may not prepay rent expense, whether the taxpayer reports on the cash or the accrual method of accounting [Rev. Rul. 55-540]. Prepaid rent is to be deducted over the term of the rental period to which the prepayment relates.

The IRS issued final regulations related to the capitalization of costs incurred to acquire or create intangible assets. These regulations included enactment of a broad "12-month rule" that has application to many prepaid expenses, including prepaid rent [T.D. 9107, 1/5/2004].

Under the 12-month prepaid expense rule, a taxpayer is not required to capitalize an amount paid in connection with a right or benefit that does not extend beyond the earlier of:

1) 12 months after the date on which the taxpayer realizes the right or benefit; or

2) The end of the tax year following the year in which the payment occurs.

This rule confirms that a cash method taxpayer is allowed a deduction for prepaying rent that does not extend beyond 12 months [Reg. 1.263(a)-4(f)(8), Example 10].

Accrual method taxpayers may not take advantage of this prepaid rent rule because of the economic performance rules of Reg. 1.461-4. These rules provide that payment for the use of property (i.e., rent) may only be deducted ratably over the period of time to which an accrual taxpayer is entitled to use the property.

Caution: Sec. 467, intended to prevent taxpayers from accelerating or deferring income in connection with lease transactions, will constrain some taxpayers from using this prepaid rent rule. When Sec. 467 applies, the cash method is disallowed and an accrual concept of ratable treatment of the rents must apply. A Sec. 467 rental agreement is one that results in increasing or decreasing rents, or prepaid or deferred rents, where the total payments under the lease equal or exceed $250,000 [Sec. 467(d)(2)].

Commentary: As a practical matter, this prepaid rent regulation adds another tool that a cash method farmer has available as part of year-end planning. However, recognize that a prepayment of rent by a farmer in December would typically cause corresponding acceleration of income to the landlord. Effectively, this new prepaid rental opportunity is probably helpful only in limited cases, such as where there is a landlord who is either not tax sensitive or reporting on a fiscal year-end. A taxpayer might prepay rent in the last days of December by use of the mailbox rule (i.e., timely mailing equals payment), but the disbursement in December requires issuance of a Form 1099-MISC to the landlord who likely received the rent in the next calendar year. This requires the landlord to make a reconciling adjustment in the tax return.

G. Prepayment by delivery or mailing of a check.

A taxpayer is permitted to claim a deduction for payment by check when that check is delivered to the payee or when placed in the mail to that payee [Rev. Rul. 80-335].

While payment may be made with borrowed funds, the funds may not be borrowed from the vendor or payee as part of the same transaction [Hager v. Comm., TC Memo 1982-663, 1982].

A purchase by credit card charge is considered a payment when the charge occurs, not later when the credit card bill is paid [Rev. Rul. 78-38 and Rev. Rul. 78-39].

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Issuing a check at year-end that exceeds funds in the taxpayer’s bank account is acceptable, providing that the check is promptly covered by the bank due to subsequent deposits. However, if the payee is instructed to hold the check, the expense is not deductible until the check is cashed [Fischer v. Comm., 14 TC 792, 1950; Blumeyer v. Comm., TC Memo 1992-647, 1992].

Fertilizer Allocations and Elections

A. Background.

A farmer is entitled to treat the purchase and application of fertilizer, lime, ground limestone, marl, or other materials used to enrich, neutralize, or condition land used in farming either as a direct expense, or as an amount to be capitalized and deducted over the useful life of the materials [Sec. 180; IRS Publ. 225, Ch. 4].

To claim current deductibility, expenditures must be made for the purchase of fertilizer and/or other materials to enrich land used in the business of farming [Reg. 1.180-1(b)].

To qualify, the expenditures should otherwise be chargeable to a capital account paid or incurred for the application of the materials to the land [Reg. 1.180-1(a)].

Expenditures for the initial preparation of land never previously used for farming purposes are not eligible for the election [Reg. 1.180-1(b)].

The election to currently expense the amount is made by claiming a deduction on the taxpayer's return. The election is effective only for the taxable year for which the deduction is claimed [Reg. 1.180-2(a)].

Once made, an election may be revoked only by obtaining the consent of the IRS. Such a request must be in writing and signed by the taxpayer or an authorized representative [Reg. 1.180-2(b)].

Revocation requests are to be sent to the address to which the taxpayer would send a mailed tax return.

B. Capitalization of amounts.

Taxpayers are allowed to capitalize fertilizer expenditures and amortize the cost over the useful life, as opposed to claiming an immediate expense deduction. A sample statement to capitalize and amortize follows at the end of this topic.

The fertilizer costs should be amortized based on the percentage of use or benefit each year, as opposed to straight-line amortization [IRS Publ. 225, Ch. 4].

Commentary.

If a farmer has low taxable income and finds that personal exemptions or itemized/standard deductions are wasted, or that the current year tax bracket is much lower than normal years, the tax preparer should consider capitalization of current year fertilizer expenditures.

If expenditures are capitalized, it may be helpful for the taxpayer to seek agronomy advice regarding the portion of capitalized fertilizer to be amortized each year.

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The decision to capitalize expenditures can be made as late as actual preparation of the tax return; this opportunity represents one of the few after-the-fact tax planning opportunities available to taxpayers.

C. Allocation to residual fertilizer in a land purchase.

IRS MSSP guidelines.

In the Market Segment Specialization Program (MSSP) guideline on Grain Farmers [Training 3149-122, Chapter 12, 7/95], the IRS discusses the possibility of allocating part of the purchase price of farmland to residual fertilizer.

The MSSP guide states: “The IRS has denied such deductions when the farmer was unable to provide data indicating the level of soil fertility attributable to the previous owner. The farmer should be able to prove beneficial ownership of the residual fertilizer supply, the presence and extent of the residual fertilizer, and that the residual fertilizer is, in fact, being exhausted.”

The guide directs the IRS examiner to “determine if the value assigned to each asset acquired on the farm is reasonable.”

IRS issues advice.

A farmer could not amortize a value assigned to residual fertilizer supply upon the purchase of farmland because of two defects: (1) The individual was not the beneficial owner of the residual fertilizer supply; and (2) the taxpayer did not establish the extent of any residual fertilizer or the period of its effectiveness [TAM 9211007, 12/3/91].

The taxpayer in this ruling was a corporate farm, wholly-owned by two individuals. The individuals purchased the farmland, but the corporation purchased the buildings and other improvements, including the residual fertilizer supply in the land. The corporation amortized the residual fertilizer supply over seven years.

The IRS technical advice memo acknowledged that capitalized farm fertilizer costs may be amortized, but could not reconcile the discrepancy legally and contractually between the interest of the individuals as owners of the land and the interest of the corporation in the residual fertilizer supply.

Further, the taxpayer did not measure or quantify the level of soil fertility in the subject farm to similar parcels of land in the area, and also did not provide evidence to show over what period the residual fertilizer would be exhausted.

Recommended approach.

Multiple soil samples should be secured for the purchased farm, to determine the level of various fertilizer components in the soil (e.g., nitrogen, phosphorus, potassium, etc.).

The levels of residual fertilizer in the purchased farm should be compared to average levels of fertilizer supply that would exist in comparable farms in the locality of the purchased farm. The agronomists who assist in the soil samples in the first step may be able to provide data or an opinion as to average levels of fertilization in the area.

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Assuming that the purchased farm contains residual fertilizer quantities that are in excess of area averages (such that the price of the land can be considered as containing a premium for residual fertilizer), this excess needs to be valued. Value can be determined by applying current fertilizer costs to the number of pounds input that would be required to produce the excess soil fertility that exists for the purchased farm.

An agronomist’s opinion should also be secured to determine the expected amortization or consumption of this excess fertilizer supply by mineral by year.

______

Election to Capitalize and Amortize Fertilizer

Under Sec. 180, the taxpayer has declined to make the election permitted by Sec. 180(a) to immediately expense fertilizer and other soil nutrients for calendar year _____. Accordingly, such expenditures are capitalized and amortized over their useful life. Expenditures for fertilizer of a capital nature incurred are as follows:

Description Amount

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Soil and Water Conservation Expenditures

A. Background.

In general, earthen improvements and land improvements such as the construction of ponds represent capital expenditures that must be added to the basis of the land.

However, Sec. 175 provides a special opportunity for taxpayers in the business of farming to currently deduct these improvements and other soil and water conservation expenses.

B. Definition of deductible conservation expenses.

Deductible soil and water conservation expenditures include:

The treatment or movement of earth, such as leveling, conditioning, grading, terracing, and contour furrowing;

The construction, control and protection of diversion channels, drainage ditches, irrigation ditches, earthen dams, water courses, outlets and ponds;

The eradication of brush; and

The planting of windbreaks [Sec. 175(c)(1)].

Soil and water conservation expenditures also include amounts paid or incurred to satisfy an assessment levied by a soil and water conservation or drainage district for these expenditures.

Soil and water conservation expenses are deductible only if they are consistent with a plan approved by the Natural Resources Conservation Service (NRCS) of the Department of Agriculture. If no such plan exists, the expenses must be in conformity with the plan of an applicable state or local agency, as follows:

NRCS individual site plans, issued individually to farmers who request assistance to develop a conservation plan designed specifically for their farmland;

NRCS county plan, based on a listing of farm conservation practices approved for the county; or

Comparable state agency plans [Sec. 175(c)(3); IRS Publ. 225, Ch. 5].

Commentary: Deductible soil and water conservation expenses do not include costs for structures such as tanks, reservoirs, pipes, culverts, canals, dams, wells, or pumps composed of masonry, concrete, tile, metal or wood. These expenditures must be recovered through annual depreciation allowances [IRS Publ. 225, Ch. 5].

C. 25% deduction limit.

The deduction for soil and water conservation expenditures cannot exceed 25% of gross income from farming.

Any deduction in excess of the 25% limit is carried to the succeeding taxable year, and is again subject to the 25% gross income limitation [Sec. 175(b)].

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Example 1 Application of 25% gross income limitation

Al, a farm equipment retailer, operates a small grain farm as a sideline activity, reporting the income and expenses on Schedule F as a farm proprietor. During 20X1, Al incurs $5,300 of deductible soil and water conservation expenditures for terracing and the construction of a pond. However, in 20X1, Al deferred most of his grain sales to the next year and only reports $20,000 of gross farm income. Al may deduct $5,000 of the qualifying soil and water conservation expenditures (25% x $20,000), and must defer the remaining $300 to 20X2.

D. Ineligible expenditures.

Improvements to land not previously used in farming are ineligible. However, prior farming activity by a different taxpayer or a different form of use, such as livestock grazing, is considered land previously used in farming and expenditures in these situations qualify [Reg. 1.175-4(a)].

Land clearing expenditures which prepare land for farming must be added to land basis.

Fixed rent landlords.

Landlords who receive a fixed rent without reference to farm production on the land are ineligible, because they are not considered to be engaged in the business of farming.

On the other hand, landlords who receive a share rental, or a cash rent that is based on farm production, are considered engaged in farming and are allowed to claim Sec. 175 soil and water conservation expenditures [Reg. 1.175-3].

Expenses that may be allowable as repairs and maintenance or other currently deductible items under Sec. 162 as ordinary and necessary business expenses are not claimed as Sec. 175 soil and water conservation expenditures (e.g., the removal of sediment from a drainage ditch) [Reg. 1.175-2(b)(2)].

Expenditures in connection with the draining or filling of wetlands are ineligible, as well as costs to prepare land for center pivot irrigation systems [Sec. 175(c)(3)(B)].

E. Claiming the deduction.

Soil and water conservation expenditures are claimed as a current expense in the year of payment by entering the amount on line 12 of Schedule F, Form 1040.

If a taxpayer chooses not to deduct the expenses, they must be capitalized (typically as nondepreciable land costs).

Accounting method status.

The decision to deduct or to capitalize is made in the first year soil and water conservation expenses are incurred. This establishes the taxpayer’s method of accounting [Sec. 175(d)(1)].

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Deducting soil and water conservation expenses (or alternatively capitalizing these expenditures) is a method of accounting. Once established, the method is to be adhered to for all subsequent years [Sec. 175(e)].

A change in an established accounting method for soil and water conservation expenditures requires IRS consent by written request to the IRS Service Center in Cincinnati, Ohio. Form 3115 is not to be used [Sec. 175(e);IRS Publ. 225, Ch. 5].

F. Recapture of previously deducted soil and water conservation expenses.

Recapture applies if farmland on which a soil and water conservation deduction was claimed is disposed of within 10 years of its acquisition [Sec. 1252].

The recapture, reported as ordinary income, is the lesser of the gain on the sale of the land, or the prior soil and water conservation deductions multiplied by a recapture percentage.

The recapture percentage is 100% if the land is disposed of within five years of acquisition. The percentage is reduced by 20% for each additional year the land is held, such that no recapture applies if the land has been held at least ten years.

Commentary: Note that this recapture provision is measured from the date of acquisition of the farmland, not from the date of the Sec. 175 deductible soil and water conservation expense.

Inventory Accounting

A. Background.

To properly reflect taxable income, inventories must be maintained in every case in which the production, purchase, or sale of merchandise is an income-producing factor for the taxpayer [Reg. 1.471-1].

Taxpayers required to account for inventories under Sec. 471 are also required to use an accrual method of accounting with regard to purchases and sales of merchandise [Reg. 1.446-1(c)(2)(i)].

B. Accounting for inventories changed for small taxpayers under TCJA.

Cash method farmers deduct all expenses of carrying on the business of farming [Reg. 1.162- 12(a)]. They do not maintain inventories of crops or animals raised.

Taxpayers meeting the gross receipts test are exempt from inventory accounting [Sec. 471(c)].

These businesses may account for their inventories either [Sec. 471(c)(1)(B)]:

As non-incidental materials and supplies; or

In conformity with their book method of accounting.

Any change in method of accounting pursuant to this rule is made under the automatic consent procedures with a Sec. 481(a) adjustment [Sec. 471(c)(4)].

The designated automatic accounting method change number is 235.

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The 5-year rule does not apply if the change is made in one of taxpayer’s first three tax years beginning after December 31, 2017.

A change in method to be exempt from Sec. 471 can be filed on the same Form 3115 as an accrual to cash change.

Commentary: Consent granted for this change is not a determination by the IRS that the proposed inventory method of accounting is permissible; it does not create any presumption that the proposed method is permissible under a provision of the Code [Rev. Proc. 2018-31, sec. 22.19 as modified by Rev. Proc. 2018-40].

Commentary: The exemption from required inventory accounting is independent of the overall method of accounting.

Example 1 Inventories as non-incidental materials and supplies

FACTS:  John is a sole proprietor farmer who meets the gross receipts test.  John reports income using the overall cash method of accounting.  Prior to 2018, John’s balance sheet reflected his inventory of livestock purchases on the cost method.  After 2017, John no longer reflects livestock purchases as inventory on his balance sheet.  His financial statements do not report income under general accepted accounting principles.

RESULT:  John may choose to account for inventory under Sec. 471 (full absorption), as non-incidental materials and supplies (i.e., deduct when consumed or sold), or expense in accordance with his book method of accounting.

Commentary: Changing the tax method of accounting for purchased livestock requires an automatic change Form 3115.

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SESSION FIVE – 3:05-3:45 p.m. THE PASSIVE LOSS RULES

The passive loss rules can have a substantial impact on taxpayers. Until 1987, it was commonplace for investors in real estate to incur losses on the investment which could be used to offset the investor's wage or other income. However, in 1986, Congress enacted the passive loss rules with the intent of limiting (or eliminating) such deductions.65 Those rules reduce the possibility of offsetting passive losses against active income unless the taxpayer materially participates in the activity.

The Basic Concept

The passive loss rules apply to activities that involve the conduct of a trade or business in which the taxpayer does not materially participate on a basis which is regular, continuous and substantial.66 and to any rental activity (regardless of the level of participation, except as provided in I.R.C. §469(c)(7), the “real estate professional” exception). If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains). The losses can only offset income from a passive activity.

Observation. The passive loss rules are likely to be encountered in situations where the taxpayer is a passive investor in a separate business venture apart from the taxpayer’s active business. In that case, the losses from the venture cannot be used to offset the income from the active business. The rules also get invoked when a taxpayer loses money in an activity that is a determined to be a hobby under the hobby loss rules.

Unless an investor or other individual can meet one of two critical tests, the passive loss rules apply. The first of these tests is the test of material participation. The second test is that of the real estate professional (see below).

Material Participation

If the taxpayer can satisfy the material participation test, then passive losses can be deducted against active income. An investor is treated as materially participating in an activity only if the person “is involved in the operation of the activity on a basis which is regular, continuous, and substantial.”67

Example. Dr. Pepper is a physician who also materially participates (defined below), in a farming or activity. Dr. Pepper will be able to use the losses from the farming or ranching activity as a deduction against his income from the practice of medicine.

65 I.R.C. §469. 66 I.R.C. §469(h)(1). 67 Id.

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Note. A Committee Report and the regulations state that activities of an agent are not attributed to an individual taxpayer and the individual must personally perform sufficient services to establish material participation. Indeed, an individual’s own participation is not taken into account if a paid manager participates in the activity and someone else performs services in connection with management of the activity which exceed the amount of service performed by the taxpayer.68

Satisfying material participation

A taxpayer can qualify as materially participating if the taxpayer materially participates for five or more years in the eight-year period before retirement or disability. In addition, the material participation test is met by surviving spouses who inherit qualified real property from a deceased spouse if the surviving spouse engages in “active management.” C corporations are treated as materially participating in an activity with respect to which one or more shareholders, owning a total of more than 50 percent of the outstanding corporate stock, materially participates.69 In other words, the corporation must be organized such that at least one shareholder materially participates, and the materially participating shareholders own more than 50 percent of the corporate stock. Estates and trusts, except for grantor trusts are treated as materially participating (or as actively participating) if a fiduciary meets the participation test.70

Regulations. In February 1988, the IRS issued temporary regulations specifying the requirements for the material participation test.71 The temporary regulations lay out seven tests for material participation (only one of which needs to be satisfied):72

 500 hours. Under the first test, an individual is considered to be materially participating if the individual participates in the activity for more than 500 hours during the year.73 This is a substantial amount of time; almost ten hours per week. In fact, this is more time than some tenants put into the operation on an annual basis. As a result, this test is exceedingly difficult for most investors to satisfy.  “Substantially all participation.” The second test involves situations where an individual's participation is less than 500 hours, but constitutes “substantially all of the participation” in the activity by all individuals during the year.74 In other words, if the investor puts in less than 500 hours annually in the activity, but substantially all of the involvement comes from the investor, the material participation test will be satisfied.

Note. It is not likely that an investor can meet this test (or the next test) if a tenant is involved. A tenant will probably put more time in than the investor.

68 See, e.g., Robison v. Comm’r, T.C. Memo. 2018-88. 69 Treas. Reg. §1.469-1T(g)(3)(i)(A). 70 See, e.g., Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003); Aragona Trust v. Comr., 142 T.C. 165 (2014). 71 Treas. Reg. 1.469-5T. 72 Only one of the seven tests for material participation need be satisfied by an individual taxpayer. If an individual holds an interest in a trade or business through a limited partnership interest, the only way to satisfy material participation is via either the 500-hour, personal service activity or facts and circumstances test. For this purpose, an LLC interest is not treated as a limited partnership interest. Thus, any of the seven tests can be utilized for purposes of satisfying material participation. See, Garnett v. Comr. 132 T.C. 368 (2009); Thompson v. Comr., 87 Fed. Cl. 728 (2009). 73 Treas. Reg. §1.469-5T(a)(1). 74 Treas. Reg. §1.469-5T(a)(2).

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 100 hours. An individual is considered to be materially participating if the individual puts more than 100 hours per year into the activity and the individual's participation is not less than that of any other individual.75

 “Significant participation.” An individual is treated as materially participating in significant participation activities if the individual's aggregate participation activities for the year exceed 500 hours.76 A “significant participation activity” is a trade or business activity in which the individual participates for more than 100 hours for the taxable year. This is an aggregate test.

Example. Mike owns a farm, two fast food restaurants, and a convenience store. If Mike puts in more than 100 (but less than 500) hours in each activity, he can aggregate them together to determine if the 500- hours test is satisfied.

 Prior 10 years. Under the fifth test the individual is treated as materially participating if the individual materially participated in the activity for any five of the ten taxable years immediately preceding the taxable year at issue.77

Note. The idea behind this rule is that substantial involvement over a lengthy period indicates that the activity was probably the individual's principal livelihood. This is a very useful test for a retired taxpayer who has had several years of involvement.

 Personal service activities. A taxpayer is treated as materially participating in a personal service activity for a taxable year if the taxpayer materially participated in the activity for any three taxable years preceding the taxable year in question.78 This is a test solely for personal service activities. Thus, it is a rule that can be used by taxpayer’s engaged in accounting, law practice, medicine and other professional services.

 Facts and circumstances. The “facts and circumstances” test is the test under which most investors try to qualify, and it requires that the taxpayer participate in the activity during the tax year on a basis that is regular, continuous and substantial.79

Note. For married taxpayers, the hours of the taxpayer’s spouse count.80

What a taxpayer does for any other purpose (such as material participation for Social Security purposes), does not count for purposes of the material participation test.81 In addition, the facts and circumstances test cannot be satisfied unless the taxpayer participates more than 100 hours in the activity during the year as a threshold requirement.82 What counts are hours in which the taxpayer is directly involved in the daily management of the trade or business.83 Also, as noted above, if the taxpayer is represented by a paid manager, the taxpayer’s own record of involvement does not count.84

75 Treas. Reg. §1.469-5T(a)(3). 76 Treas. Reg. §1.469-5T(a)(4). 77 Treas. Reg. §1.469-5T(a)(5). 78 Treas. Reg. §1.469-5T(a)(6). 79 Treas. Reg. §1.469-5T(a)(7). 80 Temp. Treas. Reg. §1.469-5T(f)(3). 81 Treas. Reg. §1.469-5T(b)(2)(i). 82 Treas. Reg. §1.469-5T(b)(2)(iii). 83 Treas. Reg. §1.469-5T(f)(2)(ii). 84 Treas. Reg. §1.469-5T(b)(2)(ii)(A).

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Observation. The maintenance of good books and records is critical to establishing material participation. Failure to do so is a leading cause of taxpayer failure to establish material participation. Although any reasonable means of documenting participation in an activity is permissible, contemporaneously prepared logs, time reports, appointment books, calendars and narrative summaries should be utilized.

Real Estate Professionals A rental activity is normally treated as “per se” passive by law. This means no amount of participation can make activity nonpassive. If the taxpayer is deemed to be a “real estate professional,” however, then the rental activity is treated instead as a trade or business for passive activity purposes, permitting material participation to change the character of the rental activity to nonpassive. 85

Observation. The rule that rentals activities are per se passive activities is also a concern because of the Net Investment Income Tax (NIIT).86 The NIIT imposes an additional tax of 3.8 percent on passive income, including passive rental income. However, the rents are not passive (and not subject to the NIIT) if the taxpayer is a qualifying real estate professional and the income is derived in the ordinary conduct of a trade or business.

Legislative history. As originally enacted, a passive activity was defined to include any rental activity regardless of how much the taxpayer participated in the activity. This barred rental activities from being used to shelter the taxpayer’s income from other trade or business activity. Rental activities could often produce a tax loss — particularly due to depreciation deductions — while the underlying property simultaneously appreciated in value. The rule was especially harsh on real estate developers with multiple development projects. One project would be developed and sold while another project would be rented out. In this situation, the developer had two activities: one that was the taxpayer’s trade or business activity (non-passive); and one that was a rental activity (passive). Any loss from the passive activity was carried forward until the taxpayer either generated passive income or disposed of the rental property in a fully taxable transaction.87 This produced a different result than could be achieved for taxpayers in non-real estate trades or businesses. For example, if a farmer lost money on the livestock side of the business while making money on the crop portion, the livestock loss would offset the crop income. To address this perceived inequity, the Congress amended the passive loss rules in 1993 to provide a narrow exception to the per se categorization of rental activities as passive. Under the exception, a “real estate professional” that materially participates in a rental activity is not engaged in a passive activity.88 Thus, rental activities remain passive activities unless the taxpayer satisfies the requirements to be a real estate professional. This means that taxpayers with rental losses who are classified as a real estate professional do not have per se passive losses. Instead, those losses can qualify to be used without limitation if the taxpayer materially participates in the real estate rental activities. Tests. To be a real estate professional, two tests must be satisfied:89  More than 50 percent of the personal services that the taxpayer performs in all trades or business for the tax year must be performed in real property trades or businesses in which the taxpayer materially participates; and

85 I.R.C. §469(c)(7). Qualification as a real estate professional is not elective. 86 I.R.C. §1411. 87 I.R.C. §§469(b), (g). 88 I.R.C. §469(c)(7). 89 I.R.C. §469(c)(7)(B).

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 The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

Observation. It will likely be very difficult for a taxpayer with a full-time job that is not in a real property trade or business to satisfy the tests, particularly the 50 percent test.90

Two key points concerning the tests must be kept in mind: (1) Only the hours a taxpayer spends in real property trades or businesses in which the taxpayer materially participates will count towards the two tests; and (2) if the two tests are satisfied, as noted above, the rental activity is no longer presumed to be passive and, if material participation is present, the rental activity is non-passive.91

Note. The issue of whether a taxpayer is a real estate professional is determined on an annual basis.92 What is a real property trade or business? To qualify for the real estate professional exception, the taxpayer must perform services in a real property trade or business. Under I.R.C. §469(c)(7)(C), those are: real property development; redevelopment construction; reconstruction; acquisition; conversion; rental; operation; management; leasing; or brokerage.

Mortgage brokers and real estate agents. Mortgage brokers and real estate agents present an interesting question as to whether they are engaged in a real estate trade or business. In general, a mortgage broker is not deemed to be engaged in a real property trade or business for purposes of the passive loss rules. That’s the outcome even if state law considers the taxpayer to be in a real estate business. What the courts and IRS have determined is that brokerage, to be a real estate business, must involve the bringing together of real estate buyers and sellers. It doesn’t include brokering financial instruments.93 The definition of a real estate trade or business also does not include mortgage brokering.94 But, if a licensed real estate agent negotiates real estate contracts, lists real estate for sale and finds prospective buyers, that is likely enough for the agent to be deemed to be in a real estate trade or business for purposes of the passive loss rules.95

Licensed appraiser. A licensed real estate appraiser might also be determined to be in a real estate trade or business if the facts are right.96 A real estate appraisal business involves direct work in the real estate industry. But, associated services that are only indirectly related to the trade or business of real estate (such as a service business associated with real estate) would not seem to meet the requirements of I.R.C. §469(c)(7).97

Note. The IRS takes the position in its audit technique guide for passive activities that services that are indirectly related to work in the real estate industry do not constitute a real estate trade or business. See IRS Passive Activity Loss Audit Technique Guide at www.irs.gov/pub/irs-mssp/pal.pdf

90 See, e.g., Hassanipour v. Comr., T.C. Memo. 2013-88; Escalante v. Comr., T.C. Sum. Op. 2015-47; Lee v. Comr., T.C. Memo. 2006-193; but see Miller v. Comr., T.C. Memo. 2011-219. 91 I.R.C. §469(c)(7)(A)(i). 92 See, e.g., Bailey v. Comr., T.C. Memo. 2001-296. 93 See, e.g., Guarino v. Comr., T.C. Sum. Op. 2016-12; C.C.A. 201504010 (Dec. 17, 2014). 94 See, e.g., Hickam v. Comr., T.C. Sum. Op. 2017-66. 95 See, e.g., Agarwal v. Comr., T.C. Sum. Op. 2009-29. 96 See, e.g., Calvanico v. Comr., T.C. Sum. Op. 2015-64. 97 The IRS position is that a lawyer or accountant working with real estate clients is not directly engaged in the real estate business and, thus, is not engage in a real property trade or business. See IRS Passive Activity Loss Audit Technique Guide at https://www.irs.gov/pub/irs-mssp/pal.pdf.

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Management companies. A real estate management company is generally engaged in the real estate business.98 Services performed that directly relate to the real estate business would count – putting together rental arrangements, managing leases, dealing with tenant housing, etc. However, economic related services such as cropping and livestock decisions for farm and ranch activities are only indirectly related to the real estate. The same can be said for legal and accounting services, for example.99

Note. A taxpayer must have at least a five percent ownership in the management company for the taxpayer’s hours to count toward the I.R.C. §469(c)(7) real property trade or business requirement.100 This will bar from qualification most taxpayers that are employed by a real estate management company but do not directly perform real estate work.

Multiple activities and grouping. A taxpayer that is a real estate professional, under the general rule, must establish material participation in each rental activity separately.101 However, the Regulations provide that a real property trade or business can be comprised of multiple real estate trade or business activities.102 This implies that multiple real estate trade and business activities can be grouped together into a single activity. That is, indeed, the case. Treas. Reg. §1.469-4 allows the grouping of activities that represent an “appropriate economic unit.” Under that standard, non-rental activities cannot be grouped with rental activities unless they meet the appropriate economic unit test. However, two or more rental activities may be grouped with each other. Consequently, if necessary, a taxpayer not materially participating in individual rental activities may group two or more of the rental real estate activities to establish material participation for purposes of determining real estate professional status. The grouping of separate rental activities may allow the taxpayer to meet the more than 750-hour test and the more than 50% test. Furthermore Treas. Reg. §1.469-9(g) allows a real estate professional to group all interests in rental activities as a single activity.103 If this election is made, the real estate professional must add all of their time spent on all of the rental activities together for purposes testing material participation in the rental real estate activity.104 The grouping election is made by filing a statement with the taxpayer’s original tax return for the tax year that contains a statement that the taxpayer is a qualified real estate professional for the tax year and is making the election subject to I.R.C. §469(c)(7)(A). The election cannot be made by simply

98 See, e.g., Stanley v. United States, No. 5:14-CV-05236, 2015 U.S. Dist. LEXIS 153166 (W.D. Ark. Nov. 12, 2015), nonacq., A.O.D. 2017-07 (Oct. 16, 2017). 99 Id. While the court noted that the taxpayer’s hours providing legal services counted toward the real estate professional tests, the taxpayer owned and worked for the real estate management company and also served as its general counsel. The court noted that I.R.C. §469 does not require services performed in a real property trade or business to be of any particular character or that all of the services be directly related to real estate. The services need only be performed in a real property trade or business in which the taxpayer materially participates. It is noted, however, that the IRS issued a non-acquiescence to the court’s decision. Id. 100 I.R.C. §469(c)(7)(D)(ii); Treas. Reg. §1.469-9(c)(5). 101 I.R.C. §469(c)(7)(A)(ii). 102 I.R.C. §469(c)(7)(A), flush language; Treas. Reg. §1.469-9(d)(1). 103 The election cannot be made unless the taxpayer is a qualifying real estate professional and has no effect in years that the taxpayer is not a qualifying real estate professional. Treas. Reg. §1.469-9(g)(1). In addition, the election is an “all-or-nothing” election. If the election is made, all of the taxpayer’s rental activities will be grouped for purposes of testing for material participation. In addition, any new rental activity that the taxpayer acquires in a year after the grouping election is in place will be subject to the grouping election. 104 Any non-rental activity is not included in the grouping. Only the hours spent in the rental activities can count toward material participation for purposes of grouping. See, e.g., Bailey v. Comr., T.C. Memo. 2001- 296.

181 aggregating all of the taxpayer’s rental activities into one column on Schedule E.105 The grouping election is binding for the tax year in which it is made. It is also binding for all future years that the taxpayer is a qualifying real estate professional. The failure to make the election in one year does not bar the election from being made in a later year.106

Note. Regroupings are not allowed in later years unless the facts and circumstances change significantly, or the initial grouping was clearly not appropriate.107 To revoke the election for such a year, a statement must be filed with the taxpayer’s original tax return for the year of revocation. The statement must contain a declaration that the taxpayer is revoking the election under I.R.C. §469(c)(7)(A) and an explanation of the nature of the change in the facts and circumstances.108

What happens if the taxpayer makes the election to aggregate all real estate rental activities but not all of the taxpayer’s interests in real estate activities are held individually by the taxpayer? The regulations address this possibility and use an example an interest in a rental real estate activity held by the taxpayer as a limited partnership interest.109 The result is that the effect of the aggregation election doesn’t necessarily apply in this situation. Instead, the taxpayer’s combined rental activities are deemed to be a limited partnership interest when determining material participation and the taxpayer must establish material participation under one of the tests that apply to determine the material participation of a limited partner contained in Treas. Reg. 1.469-5T(e)(2).110

But, there is a de minimis exception that applies if the taxpayer’s share of gross rental income from all limited partnership interests in rental real estate is less than 10 percent of the taxpayer’s share of gross rental income from all of the taxpayer’s interests in rental real estate for the tax year. In this situation, the taxpayer can determine material participation by using any of the tests for material participation in Treas. Reg. §1.469-5T(a) that apply to rental real estate activities.111 This is also the rule if the taxpayer has an interest in a rental real estate activity via an LLC. An LLC interest is not treated as a limited partnership interest for this purpose. Thus, the taxpayer can use any of the seven tests for material participation contained in Treas. Reg. §1.469-5T(a).112

105 See, e.g., Kosonen v. Comr., T.C. Memo. 2000-107. 106 If a timely election is not made, a late election can be made if tax returns have been filed that are consistent with having made the election for all tax years for which the taxpayer is seeking late relief. The procedures set forth in Rev. Proc. 2011-34, 2011-24 IRB 875 must be followed to make a late election. The ability to make a late election can be very important. See, e.g., Estate of Ramirez v. Comr., T.C. Memo. 2018-196. 107 Treas. Reg. §1.469-9(d)(2). 108 Treas. Reg. §1.469-9(g)(3). 109 Treas. Reg. §1.469-9(f)(1). 110 Treas. Reg. §1.469-9(f)(1). 111 Treas. Reg. §1.469-9(f)(2). 112 See, e.g., Garnett v. Comr., 132 T.C. 368 (2009); Hegarty v. Comr., T.C. Sum. Op. 2009-153; Newell v. Comr., T.C. Memo. 2010-23; Thompson v. Comr., 87 Fed. Cl. 728 (2009), acq. in result only, A.O.D. 2010- 002 (Apr. 5, 2010); Chambers v. Comr., T.C. Sum. Op. 2012-91.

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Observation. In its 2017-2018 Priority Guidance Plan, the IRS stated that it planned to finalize regulations under I.R.C. §469(h)(2). That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011. Until the IRS takes action to effectively overturn the Tax Court decisions via regulation, the issue will boil down to an analysis of a particular state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership.

Note. Once the election is made, the combined rental real estate activity is treated as a single activity for all I.R.C. §469 purposes. Thus, for example, passive losses attributable to a grouped activity that the taxpayer disposes of are not available until the taxpayer disposes of substantially all of the grouped rental activity.

In Chief Counsel Advice 201427016,113 the IRS stated that the Treas. Reg. §1.469-9(g) aggregation election “is relevant only after the determination of whether the taxpayer is a qualifying taxpayer.” Thus, whether a taxpayer is a real estate professional for purposes of the passive loss rules is not affected by an election under Treas. Reg. §1.469-9(g). In other words, the election under Treas. Reg. 1.469-9(g) has no bearing on the issue of whether a taxpayer qualifies as a real estate professional – puts in more than 750 hours in real estate activities and satisfies the 50 percent test.114 But, grouping can make it easier for the taxpayer to meet the required hours test of I.R.C. §469(c)(7) and be deemed to be materially participating in the activity Establishing a taxpayer as a real estate professional. For taxpayers with multiple real property trades or businesses, various steps are involved in making the determination of whether the taxpayer qualifies as a real estate professional.  The first step in determining whether the taxpayer qualifies as a real estate professional is to identify and group the taxpayer’s various real property trade or business activities.  The next step, once the taxpayer’s various real property trade or business activities have been identified, is to determine in which activities the taxpayer materially participates (under one of the seven tests identified above).  The hours of the taxpayer’s participation in the combined real property trades or business in which the taxpayer materially participates should then be added together. These total hours of participation should be applied in determining whether the taxpayer has spent more than 50% of their total time for the year in all activities (passive and nonpassive) in the combined real property trades or businesses and whether that is more than 750 hours. A determination will need to be made as to whether these total hours exceed 750. If both of these requirements are satisfied, the taxpayer qualifies as a real estate professional.115

113 Apr. 28, 2014. In the CCA, the IRS conceded in Jafarpour v. Comr., T.C. Memo. 2012-165, that the election applies only after a taxpayer has qualified as a real estate professional and only for the purpose of determining material participation in the real estate professional’s rental activities. 114 See also Miller v. Comr., T.C. Memo. 2011-219. 115 Good recordkeeping is imperative to substantiate qualification of these tests. Hours spent “on-call” for tenants don’t count toward the 750-hour test unless services are actually performed during the on-call hours. See Moss v. Comr., 135 T.C. 365 (2010). On the substantiation issue, see also Harnett v. Comr., T.C. Memo. 2011-191, aff’d., 496 Fed. Appx. 963 (11th Cir. 2012); Lewis v. Comr., T.C. Sum. Op. 2014-12; Leyh v. Comr., T.C. Sum. Op. 2015-27.

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Note. Married spouses that file a joint return are qualifying taxpayers only if one spouse separately satisfies the two tests for real estate professional status of I.R.C. §469(c)(7)(B) without regard to the services performed by the other spouse.116 Thus, the taxpayer-wife who files separately cannot rely on her husband’s activities to satisfy the I.R.C. §469 tests for the exception for real estate professionals.117 However, once a taxpayer qualifies as a real estate professional, material participation in the rental real estate activities material participation is determined by taking the spouse’s participation into account.118 This spousal attribution rule (for purposes of determining material participation) applies regardless of whether the spouses file a joint return.

Example. Hayden is a full-time salesman and his wife, Abbey, is a full-time office manager. They also own rental properties that sustained losses that they wished to fully deduct. They maintain time logs that showed their hours spent on their real estate rental activities. Abbey seeks to qualify as real estate professional under I.R.C. §469(c)(7). They filed a joint return. Abbey will have to show that she satisfies both the 750-hour test and the 50 percent test in her own regard. Assuming she qualifies as a real estate professional, the determination of whether Abbey materially participated in the rental activities can be satisfied by taking into account Hayden’s material participation, if any. They could also file an election to treat all of the rental activities as a single activity. If they can’t satisfy the material participation test, they might be able to deduct up to $25,000 of losses under the small investor exception of active participation contained in I.R.C. §469(i) (not covered in these materials) .119

Observation. To restate, satisfaction of the 50 percent test and the 750-hour test of I.R.C. §469(c)(7) qualifies the taxpayer as a real estate professional. It does not, however, mean that the rental activities are presumed to be nonpassive. To have the rental activities treated as nonpassive requires that the taxpayer materially participates in each separate rental activity unless an aggregation election is made under Treas. Reg. §1.469-9.

Once it is established that the taxpayer qualifies as a real estate professional, material participation must be established. Each rental activity in which the taxpayer materially participates is treated as nonpassive. Rental activities in which the taxpayer does not materially participate are passive even though the taxpayer is a real estate professional.120

Note. A taxpayer that qualifies as a real estate professional, but has passive real estate rental losses can use those losses to the extent that I.R.C. §469(i) (the $25,000 small investor exception) allows.

As noted above, as a real estate professional the taxpayer could elect to aggregate all rental activities for purposes of satisfying the material participation test in the aggregated activity. If the test is satisfied, then the aggregated activities are nonpassive. The converse is also true. If the material participation test is not satisfied, then all of the aggregated activities are passive.

Trusts The IRS has taken the position that only an individual can be a real estate professional for purposes of the passive loss rules.121 That’s important as applied to trusts. Much rental property is held in trust. Thus, according to the IRS position, the only way the trust rental income would not be passive is if the trustee,

116 Conf. Rept. No. 103-213, P.L. 103-66, p. 547. See also Treas. Reg. §1.469-9(c)(4). 117 See, e.g., Oderio v. Comr., T.C. Memo. 2014-39. 118 IRS Pub. No. 925 (2018), p. 6. 119 For a case discussing these various aspects of I.R.C. §469, see Martin v. Comr., T.C. Memo. 2018- 109. 120 See, e.g., Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016); Perez v. Comr., T.C. Memo. 2012- 232. 121 C.C.A. 201244017 (Nov. 2, 2012).

184 acting in the capacity as trustee, satisfies the tests of I.R.C. §469(c)(7). The one federal district court that has addressed the issue has rejected the IRS position.122 But, the Tax Court has held otherwise. In Frank Aragona Trust v. Comr.,123 a trust incurred losses from rental activities which the IRS treated as passive. The trust had six trustees – the settlor’s five children and an independent trustee. One of the children handled the daily operation of the trust activities and the other trustees acted as a managing board. Also, three of the children (including the one handling daily operations) were full-time employees of an LLC that the trust owned. The LLC was treated as a disregarded entity and operated most of the rental properties. The trust had essentially no activity other than the rental real estate. The IRS, in treating the losses as passive said that the trustees were acting as LLC employees and not as trustees. The Tax Court disagreed with the IRS position, finding that the trust materially participated in the rental real estate activities and that the losses were non-passive. The trustees, the Tax Court noted, managed the trust assets for the beneficiaries, and if the trustees are individuals and work on a trade or business as part of their duties, then their work would be “performed by an individual in connection with a trade or business.” Thus, a trust, rather than just the trustees, is capable of performing personal services.

Observation. The Tax Court’s position in Frank Aragona Trust is particularly important for many rental activities, including those involving farm and ranch land. A great deal of leased real estate is held in trust. The trust may be able to meet the material participation standard via the conduct of the trustees. That would allow full deductibility of losses. In addition, the trust income would not be subjected to the additional 3.8 percent tax of I.R.C. §1411.

Self-Rentals Creating passive income and the risk of recharacterization. Many taxpayers seek to avoid passive losses. Other than materially participating as described earlier, there may be an incentive for a taxpayer to be involved in activity that generates passive income that could then be offset by passive losses from another activity. Indeed, when the passive loss rules became law, there was immediate interest in creating what came to be known as passive income generators (PIGs). These are investment activities that throw off passive income, allowing the investor to match the passive income from the activity against passive losses. The IRS anticipated this and published regulations in the mid-1980's that recharacterized, or gave the IRS the power to recharacterize, passive income as non-passive income which was ineligible to offset passive losses.124 There are ten categories of recharacterization. Two of these categories are of primary importance - the rule involving bare land leases; and the self-rental rule. Bare land leases. One recharacterization rule applies to bare land leases.125 Under this recharacterization rule, net income from a rental activity is considered not from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable.126 The rule converts both net rental income and any gain on disposition from passive income to portfolio income (i.e., income from investments, dividends, interest, capital gains). But, the recharacterization rule only applies if there is net income from the rental activity. If there is a loss, the loss remains passive. Example: Dr. Sawbones owns interests in multiple limited partnerships that have suspended losses. In an attempt to use those losses, Sawbones bought farmland for $400,000. $100,000 of the purchase price was allocated to fences, tile lines, grain bins and other depreciable property. Sawbones cash leased the land to his cousin via a cash rent lease in an attempt to generate passive income that he could offset with the

122 Mattie Carter Trust v. United States., 256 F.Supp.2d 536 (N.D. Tex. 2003). 123 142 T.C. 165 (2014). 124 This became known as the “slaughter of pigs.” 125 Treas. Reg. §1.469-2T(f)(3). 126 Id.

185 suspended passive losses. However, because only 25 percent of the unadjusted basis is attributable to depreciable property, the cash rent income is recharacterized (for passive loss rule purposes) as portfolio income and will not offset the suspended passive losses from the limited partnerships. However, if the cash rent produces a net loss after taxes, interest and depreciation, the loss is a passive loss. This is not the result that Sawbones was hoping to achieve. The regulation has been upheld as valid.127 Self-rentals. Taxpayers sometimes structure their businesses in multiple entities for estate and business planning (and tax) purposes. Such a structure may involve the individual ownership of the land that is then rented to the operating entity that the landlord also has an ownership interest in. Alternatively, the land may be held in some type of non-C corporation entity and rented to the operating entity.128 However, it’s also a classic self-rental situation that trips another recharacterization rule for passive loss purposes. Under this rule, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates.129 But, just like the recharacterization rule for bare land leases, recharacterization only applies if there is net income from the self-rental activity. If a loss occurs, the loss remains passive. While an exception exists for rentals in accordance with a written binding contract entered into before February 19, 1988, that lease must have been a rather long-term lease at the time it was entered into for the grandfathering provision to still apply.130 It’s not possible to renew or draft an addendum to the original lease and come within the exception.131 It also applies to S corporations.132 Example: For estate and business planning purposes, Mary put most of her farmland in an entity that she is the sole owner and employee of. Mary continued to own her livestock buildings, a machine shed and additional farmland, and rented them to the entity under a cash lease. Mary reported the rental income on Schedule E (Form 1040). However, because the rental income is derived from a business in which Mary materially participates, she cannot carry the rental income to Form 8582 (the passive activity loss Schedule) within her Form 1040. Instead, the net rental income is treated as coming from a non-passive activity. Mary will have to carry the net rental income from Schedule E directly to page one of her Form 1040. If Mary has passive losses from other sources, she will not be able to use those losses to offset the rental income. It’s not possible to make a grouping election to overcome the self-rental regulation.133 While a taxpayer can make an election to group multiple rentals as a single activity for passive loss rule purposes if the rental activities represent an appropriate economic unit,134 such a grouping election will not overcome the self- rental rule.

127 See, e.g., Wiseman v. Comr., T.C. Memo. 1995-303. 128 For a farm client where the lease involves the production of agricultural or horticultural products, if the land lease does not involve the landlord’s material participation and the rental amount is set at fair market value (or slightly less), self-employment tax is avoided on the rental income even though the landlord materially participates in the operating entity as an owner. See Martin v. Comr., 149 T.C. 293 (2017). 129 Treas. Reg. §1.469-2(f)(6). 130 Treas. Reg. §1.469-11(c)(1)(ii). 131 See, e.g., Krukowski v. Comr., 114 T.C. 366 (2000), aff’d., 239 F.3d 547 (7th Cir. 2002). 132 Williams v. Comr., No. 15-60341, 2016 U.S. App. LEXIS 1756 (5th Cir. Feb. 5, 2016), aff’g., T.C. Memo. 2015-76. 133 See, e.g., Carlos v. Comr., 123 T.C. 275 (2000). 134 Treas. Reg. §1.469-4(c).

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Note. As a result of the Carlos decision, it is clear that taxpayers are unable to combine a self-rental income property with any other passive loss rental property, whether the other is a self-rental or not, and thereby use profit or loss from the self-rental property against the other property. Clients with this potential issue should be alerted as to the risk. But, the separation of a self-rental property with income from other passive properties is only harmful if the other passive properties produce a loss. A risk minimization strategy that involves minimizing loss activities could include paying down debt to reduce a large interest deduction, or increase rents, if possible. If a prior grouping election has not happened, consideration should be given of the grouping of a self-rental loss with the business activity if there is identical ownership and if the taxpayer participates in the business activity.135 Also, a rental activity can be grouped with a business activity if the rental activity is insubstantial in relation to the business activity. By grouping the rental and the business together, the rental activity loss is no longer treated as passive if the owner materially participates in the business. Example: Bill and Belinda are married and file a joint return. They own two tracts of farmland and cash lease each tract to the farming entity (an S corporation) that they own and operate. One of the tracts generates cash rental income of $200,000. The other tract produces an $80,000 loss. On their Schedule E for the tax year, they group the two tracts together as a single activity with the result that the net rental income reported is $120,000. Under the self-rental regulation, the $200,000 of income from one tract is recharacterized as non-passive and the $80,000 loss remains passive and cannot offset the $200,000 income. The $80,000 loss will be a suspended passive activity loss on Form 1040. One option might be for Bill and Belinda to group the land rental activity that produces a loss with their operating entity. They can do that if the rental activity is “insubstantial” in relation to the business activity.136 In addition, they could group the rental activity that produced a loss with the operating entity (business activity) if they each have the same percentage ownership in the operating entity that they do in the rental activity. Such a grouping will result in the rental activity loss not being passive if they materially participate in the operating entity. Application to S corporations. Even though the passive loss rules of I.R.C. §469 don’t specify that they apply to S corporations, the Tax Court has held that the self-rental rule applies to rentals by S corporations. In Williams v. Comr.,137 the taxpayers (a married couple) owned 100 percent of an S corporation and 100 percent of a C corporation. The husband worked full-time for the C corporation during 2009 and 2010, and materially participated in its activities. Neither of the taxpayers materially participated in the S corporation or the rental of commercial real estate to C corporation. They also were not engaged in a real estate trade or business. In 2009 and 2010, the S corporation leased commercial real estate to the C corporation so that the C corporation could use it in its business. For those years, the S corporation had net rental income that the taxpayers reported as passive income on Schedule E which they then offset with passive losses. The IRS disagreed and recharacterized the rental income as non-passive under the self- rental rule. In upholding the IRS position, the Tax Court determined that passthrough entities are subject to I.R.C. §469 (which included the taxpayers’ S corporation) even though not specifically mentioned by the statute. They did not need to be mentioned, the Tax Court reasoned, because they were not taxpayers. The Tax Court also rejected the taxpayers’ argument that the self-rental rule didn’t apply because the S corporation did not participate in the C corporation’s trade or business. It was enough that the husband personally provided material participation in the C corporation’s business to trigger the application of the self-rental rule. The rental income from the lease was non-passive.

135 See Treas. Reg. §1.469-4(d)(1) 136 Treas. Reg. §1.469-4(d)(1). 137 T.C. Memo. 2015-76.

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The self-rental rule and the QBID. To be eligible for the QBID, a rental activity must rise to the level of trade or business in accordance with I.R.C. §162 (or be within a safe-harbor). That is a different (and more stringent) standard than that utilized for purposes of the passive loss rules of I.R.C. §469, and it requires regularity and continuity in the activity. There are many decided cases involving the issue of whether a trade or business exists under the I.R.C. §162 standard with the courts utilizing numerous factors such as the type and number of properties rented; how involved the taxpayer is in the business; whether any ancillary services are provided under the lease and, if so, the type; and, the type of the lease. These factors are also listed in the preamble to the I.R.C. §1411 regulations (the net investment income tax). In August of 2018 QBID proposed regulations were released. The proposed regulations defined “self- rentals” as a “trade or business.” Thus, the income from a self-rental will qualify for the QBID if the self- rental is being leased through a passthrough business that is under “common control.” Common control is necessary to combine rentals with other business activities and is defined when the same person or group, directly or indirectly own 50% or more of each trade or business. Example. Seth Poole is the sole owner of an S corporation that is engaged in manufacturing widgets. Seth also owns an office building that he holds in his single member limited liability company (LLC). The LLC leases the office building to the S corporation under a triple-net lease (a lease agreement where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees such as rent, utilities, etc.). Because the office building is leased between entities that are under common control, and the S corporation is carrying on a trade or business, the triple-net lease activity qualifies as eligible for the QBID. The “takeaway” from the proposed regulations was that self-rentals between entities that are under common control can produce a significant QBID. In mid-January of 2018, the Treasury released the QBID final regulations. Issued along with those final regulations was Notice 2019-07 providing safe harbor rules for rental activities on the trade or business issue. In essence, to qualify for the safe harbor, a rental real estate activity is a QBI-qualifying trade or business under I.R.C. §199A if the taxpayer provides at least 250 hours of services during the tax year. But, it is important to remember that the safe-harbor is just that – a safe-harbor. A rental activity can qualify as an I.R.C. §162 trade or business without meeting the safe harbor requirements if the facts and circumstances support such a finding. Under the final regulations, a self-rental constitutes an I.R.C. §162 trade or business for QBID purposes if the rental involves commonly controlled entities (either directly or via attribution under I.R.C. §§267(b) or 707(b)) where the self-rental income is not received from a C corporation. The final regulations also bar taxpayers from shifting SSTB income to non-SSTB status by using a self-rental activity where property or services are provided to an SSTB by a trade or business with common ownership. Under the rule, a portion of the trade or business that provides property to the commonly owned SSTB is treated as part of the SSTB with respect to the related parties if there is at least 50 percent common ownership. Example. A group of CPAs own a building. They lease 80 percent of the building space to the CPA firm and 20 percent of the building to an unrelated chiropractor. The 20 percent would be classified as non- SSTB income while the 80 percent would be treated as SSTB income. The general rule is that a rental real estate trade or business is not treated as an SSTB, subject to the taxable income limitations. However, that rule changes if there is common ownership exceeding 50 percent. If there is, the rental income attributable to the commonly controlled SSTB is treated as if it were SSTB income. The grouping of a self-rental activity with the taxpayer’s operating entity, if they are part of a common group and have the same tax year will cause the rent to be aggregated with the business income. This can optimize the use of the 20 percent qualified business income deduction of I.R.C. §199A (with the possible exception of rental to an SSTB, as noted above).

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The self-rental rule and the net investment income tax (NIIT). The 3.8 percent NIIT applies to taxpayers with passive income that exceeds $250,000 on a joint return ($125,000 married filing separately; $200,000 for other filing statuses). Generally, the passive loss rules apply in determining whether an I.R.C. §162 trade or business is passive for NIIT purposes. Thus, if a taxpayer has rental income from an activity in which the taxpayer materially participates, the NIIT will not apply. But, what about the self-rental recharacterization rule? Treas. Reg. §1.1411-5(b)(2) specifies that, “To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” by reason of . . . §1.469-2(f)(6), such trade or business does not constitute a passive activity . . . with respect to such recharacterized income or gain.” Thus, if the self-rental recharacterization rule applies, it will cause the trade or business at issue to not be passive for NIIT purposes only with respect to the recharacterized income or gain.138 When gross rental income is treated as not being derived from a passive activity because of a grouping a rental activity with a trade or business activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business.139 Thus, the NIIT would not apply.140 For purposes of the NIIT, the self-rental rule is applied on a person-by-person basis. Thus, there can be situations involving multiple owners in a rental entity where some will be subject to the NIIT and others who will not be subject to the NIIT based on individual levels of participation in the activity. There is also a spousal attribution rule. Under this rule, for example, the self-rental of property to the materially participating spouse’s business is not subject to the NIIT. Because the spouses are considered to be a unit for the regular passive loss rules, the rental income is not passive income in the hands of the spouse that is not materially participating in the business activity.141

138 Treas. Reg. §1.1411-5(b)(2)(iii). 139 Thus, any resulting gain from the sale of assets would also be non-passive. 140 Treas. Reg. §1.1411-4(g)(6)(i). 141 I.R.C. §469(h)(5). Connor v. Comr., T.C. Memo. 1999-185, aff’d., 218 F.3d 733 (7th Cir. 2000).

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SESSION SIX – 3:45-4:15 p.m.

THE 2018 FARM BILL

A. AGI Limitations

1. The 2014 Farm Bill implemented a $900,000 Adjusted Gross Income (AGI) limitation for all farms. The 2018 Farm Bill retains the same $900,000 AGI limit.

2. The limitation is first applied at the entity level. Therefore, C and S corporations, LLC, LLP, LLLP, and any other limited liability entity will each have an AGI limitation.

3. General partnerships and joint ventures do not have any AGI limit.

4. Each owner of an entity has their own separate AGI limitation.

5. The AGI limitation is based on a rolling three-year average excluding the year prior to the crop year of calculation.

a. For 2019, a farmer uses 2015, 2016, and 2017 in calculating their average AGI.

b. There are no exceptions for certain one-time gains such as a sale of a business, etc.

6. AGI determination for contracts with the USDA such as Conservation Reserve Programs (CRP) is tested only at the time the contract is signed or transferred. If the taxpayer meets the AGI test in that year, then AGI can be over the limit in any subsequent years unless the contract is transferred. The transferee must meet the AGI limit in that year.

B. Definition of AGI

1. Individuals – Line 7 of IRS Form 1040 (2018 version).

a. Note – the deduction for Section 199A is deducted below this line; therefore, this deduction does not reduce AGI for purposes of this limitation.

2. C corporations – Form 1120 (taxable income) Line 30 plus line 19 (charitable contributions).

3. S corporations – Form 1120S Line 21 (ordinary business income (loss)) minus Section 179 listed on Schedule K line 11.

4. LLCs, LLPs, etc. taxed as partnerships – Form 1065 Line 22 (ordinary business income (loss)) plus line 10 (guaranteed payments) minus Section 179 listed on Schedule K line 12.

5. Estates and Trusts – Form 1041 line 22 (taxable income) plus line 13 (charitable deductions).

C. Payment Limitations

1. The 2014 Farm Bill had a $125,000 payment limitation. The 2018 Farm Bill retains this limit. The limit applies to payments received for:

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a. Agricultural Risk Coverage (ARC), and

b. Price Loss Coverage (PLC).

2. Payments received under the Marketing Assistance Loan (MAL) program are exempt from payments limits (a change from the 2014 Farm Bill).

3. There is a separate payment limitation for peanut farmers.

4. CRP payment limits are capped at $50,000.

5. A crop share landlord is considered to be a producer and will have the same limits.

6. Expands family member to include first cousins, nephews, and nieces.

D. AGI and Payment Limit Planning

1. If the farm is fairly small, then any type of entity will not create issues.

2. If the farm is large and more than one payment limit is allowed, then a general partnership or joint venture is needed.

3. Having each owner be a single member LLC or other type of limited liability entity will accomplish liability protection and maintain the payment limits.

E. Agricultural Risk Coverage (ARC)

1. Introduced in the 2014 Farm Bill and retained in 2018 Farm Bill.

2. Benchmark Revenue is equal to five-year Olympic average (throw out high and low) of commodity price times county yield.

3. Guarantee is set at 86% of benchmark revenue.

4. Maximum payment is 10% of benchmark revenue.

5. Payment is based upon final county yield times mid-year average (MYA) price. If this number is less than guarantee, then payment is made, but limited to 10% of benchmark revenue.

6. Final payment is based on 85% of base acres.

7. Payment does not change based upon planting of acres.

8. County yields are based on where the farm is located not administered (as under the 2014 Farm Bill).

9. ARC-Individual Coverage is retained.

10. Separate irrigated and non-irrigated for covered crops.

11. The FSA will prioritize RMA data for determination of crop yields for each county.

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F. Price Loss Coverage (PLC)

1. A reference price is determined for each commodity.

2. If the final MYA price for that crop is less than the reference price, a payment is made based on difference times the PLC yield for each farm.

3. Final payment is based upon 85% of base acres.

4. No payment limit on PLC other than overall $125,000 payment limit.

G. ARC/PLC election and administration

1. Farmers will be allowed to elect on a farm-by-farm basis between ARC and PLC. The election is binding for 2019 and 2020 crop years.

2. The farmer can switch each year beginning with the 2021 crop year.

3. If no election is made, the farm retains the current election under the 2014 Farm Bill for crop years 2020-2023. No payment is allowed for crop year 2019.

4. The reference price for both ARC and PLC can increase to a maximum of 115% of the current reference price (likely not many crops will see an increase).

5. Acres that did not have any covered crops during 2014-2018 will not qualify for ARC or PLC. However, producers may elect an $18 per acre payment.

6. Producers are allowed to update their PLC payment yields.

7. Payment rates will now be published within 30 days of the end of the crop marketing year.

8. Cotton transition payments are repealed.

9. Loan rates are increased for most commodities.

H. Dairy Margin Coverage (DMC)

1. Replaces the old Margin Protection Program (MPP) under the 2014 Farm Bill.

2. Provides lower producer-paid premiums for milk coverage of 5 million pounds or less (Tier I).

3. Adds margin coverage at higher levels of coverage (up to $9.50 per hundredweight (CWT)).

4. Producers may buy coverage from $4.50 to $9.50 per CWT on first 5 million pounds of production (about 250 cows), compared to $5.50/cwt to $8/cwt under 2014 Farm Bill.

5. They may cover 5% to 95% of their production compared to 25% to 90% under MPP.

6. Margin coverage is only available up to $8/cwt for amounts over 5 million pounds of production.

7. Premium amounts are substantially less than MPP.

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8. Producers may also participate in Livestock Gross Margin-Dairy (LGM-D). This was not allowed under MPP.

9. Producers may elect to lock in coverage levels for full five years and receive a 25% discount on premiums.

I. Conservation

1. Working Land Programs provide technical and financial assistance to help farmers improve land management practices.

2. The two largest working land programs – Environmental Qualify Incentives Program (EQIP) and Conservation Stewardship Program (CSP) – account for more than half of all conservation program funding.

3. CSP is retained but funding shifts away from acres and is now based on funding ($700 million in FY2019 increasing to $1 billion in FY2023). This is reduced from prior law. These savings are redistributed to EQIP and other conservation programs.

4. EQIP is retained and expanded. Annual funding now approaches $2 billion.

5. Conservation Reserve Program (CRP) is retained and acreage expands from 24 million acres in FY2019 to 27 million in FY2023.

a. Rental payments are now limited to 85% of county average rates for general enrollment and 90% for continuous enrollment.

6. The Agricultural Conservation Easement Program (ACEP) is reauthorized and funding will expand from $250 million in FY2018 to $450 million annually from FY2019-FY2023.

J. Crop Insurance

1. The Federal Crop Insurance Corporation (FCIC) pays part of the premium (about 63%) while policy holders – farmers and ranchers – pay the balance. Private insurance companies deliver the policies. The USDA Risk Management Agency (RMA) administers the federal crop insurance program.

2. The 2018 Farm Bill expands coverage for many crops including forage and grazing.

3. Beginning farmers continue to qualify for reduced premiums for 10 years.

4. The 2018 Farm Bill adds hemp to the definition of eligible crops for federal crop insurance and removes it as a controlled substance.

5. Expands crops that may be eligible for post-harvest losses to include hemp along with potatoes, sweet potatoes and tobacco.

6. Raises the fee for catastrophic level coverage from current $300 rate to $655 per crop per county.

7. Expands enterprise units across county lines.

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Federal Farm Program Participation Active Engagement Test. For farm couples that participate in federal farm programs where one spouse satisfies the active engagement test, each spouse may qualify for a payment limitation.142 To be considered actively engaged in farming as a separate person, a spouse must satisfy three tests.143

1. The spouse’s share of profits or losses from the farming operation must be commensurate with the spouse’s contribution to the operation.

2. The spouse’s contributions must be “at risk.”

3. The spouse must make a significant contribution of capital, equipment, or land (or a combination of these) and active personal labor or active personal management (or a combination).

For the spouse’s contribution to be “at risk,” there must be a possibility that a nonrecoverable loss may be suffered. Similarly, contributions of capital, equipment, land, labor, or management must be material to the operation to be a “significant contribution.” The spouse’s involvement, to warrant separate-person status, must not be passive.

The active engagement test is relaxed for farm operations in which a majority of the “persons” are individuals who are family members. However, it is not possible for a spouse to sign up for program payments as a separate person from the other spouse based on a contribution of land the spouse owns in return for a share of the program payments. This is the case because the use of the spouse’s contributed land must be in return for the spouse receiving rent or income for the use of the land based on the land’s production or the farming operation’s operating results.

In this regard, spouses who sign up for two separate payment limitations under the farm programs are certifying that they each are actively involved in the farming operation. Under the farm program rules, for each spouse to be actively involved requires both spouses to be significantly involved in the farming operation and bear a risk of loss.

From a tax reporting standpoint, however, the couple may have a single enterprise. The income from the enterprise is reported on Schedule C as a sole proprietorship, or on a single Schedule F with the income split into two equal shares for SE tax purposes. In these situations, the IRS could assert that a partnership filing is required (in common-law property states). Under these circumstances, the QJV election could be utilized and result in filing two Schedules C. As mentioned previously, this is a simpler process than filing a partnership return, and it avoids the possibility of having penalties imposed for failing to file a partnership return.

142 7 USC §§1308-1(b); 1308-1(c)(6). 143 7 USC §1308-1(b)(2).

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Filing a QJV election subjects the income of both spouses (including each spouse’s share of government payments) to SE tax. That eliminates any argument that at least one spouse’s income should not be subjected to SE tax because the spouse was only actively involved (for purposes of the farm program eligibility rules), but not engaged in a trade or business (for SE tax purposes).

Separate “Person” Status and Material Participation. Can both spouses qualify for separate “person” status for federal farm program purposes, but have only one of them be materially participating in the farming operation for SE tax purposes? While the active engagement rules are similar to the rules for determining whether income is subject to SE tax, the satisfaction of these rules is meaningless on the SE tax issue, according to the U.S. Tax Court.

In Vianello v. Comm’r,144 the taxpayer was a CPA that operated an accounting firm in the Kansas City area during the years in issue. In 2001, the petitioner acquired 200 acres of cropland and pasture in southwest Missouri approximately 150 miles from his office. At the time of the acquisition, a tenant (pursuant to an oral lease with the prior owner) had planted the cropland to soybeans. Under the lease, the tenant deducted the cost of chemicals and fertilizer from total sale proceeds of the bean and paid the landlord one-third of the amount of the sale. The petitioner never personally met the tenant during the years at issue, but the parties did agree via telephone to continue the existing lease arrangement for 2002.

Accordingly, the tenant paid the expenses associated with the 2001 and 2002 soybean crops, and provided the necessary equipment and labor. The tenant made all the decisions about raising and marketing the crop, and paid the petitioner one-third of the net proceeds. The tenant also mowed the pasture and maintained the fences. Ultimately, a disagreement between the petitioner and the tenant resulted in the lease being terminated in early 2003, and the petitioner had another party plow under the fall-planted wheat in the spring of 2004 prior to the planting of Bermuda grass.

The petitioner bought two tractors in 2002 and a third tractor and hay equipment in 2003. He bought another 50 acres from a neighbor in late 2003.

The petitioner did not report any Schedule F income for 2002 or 2003, but did claim a Schedule F loss for each year as a result of depreciation claimed on farm assets and other farming expenses. The petitioner concluded, based on reading IRS Pub. 225, Farmer’s Tax Guide, that he materially participated in the trade or business of farming for the years at issue. The petitioner claimed he was involved in major management decisions, provided and maintained fences, and discussed row crop alternatives, weed maintenance, and Bermuda grass planting with the tenant. The petitioner also pointed out that his revocable trust was an eligible “person” under the farm program payment limitation rules because it satisfied the active engagement test. The petitioner also claimed he bore risk of loss under the lease because an unsuccessful harvest would mean that he would have to repay the tenant for the tenant’s share of chemical costs.

The Tax Court determined that the petitioner was not engaged in the trade or business of farming for 2002 or 2003. The court noted that the tenant paid all the expenses associated with the 2002 soybean crop, and made all of the cropping decisions. In addition, the court noted that the facts were unclear as to whether the petitioner was responsible under the lease for reimbursing the tenant for input costs in the event of an unprofitable harvest. Importantly, the court noted that the USDA’s determination that the petitioner’s revocable trust satisfied the active e engagement test and was a co-producer with the tenant for farm program eligibility purposes “has no bearing on whether petitioner was engaged in such a trade or business for purposes of section 162(a)…” The Tax Court specifically noted that the regulations under IRC §1402 “make it clear that petitioner’s efforts do not constitute production or the management of the production as required to meet the material participation standard.” That is a key point. The petitioner’s revocable trust (in essence, the taxpayer) satisfied the active engagement test for payment limitation purposes (according

144 Vianello v. Comm’r, TC Memo 2010-17 (Feb. 1, 2010).

195 to the USDA), but the petitioner was not engaged in the trade or business of farming either for deduction purposes or SE tax purposes. The USDA’s determination of participation is not controlling on the IRS.

Vianello reaffirms the point that the existence of a trade or business is determined on a case-by-case basis according to the facts and circumstances presented. The case provides additional clarity on the point that satisfaction of the USDA’s active engagement test does not necessarily mean that the taxpayer is engaged in the trade or business of farming for SE tax purposes. In spousal farming operations, Vianello supports the position that both spouses can be separate persons for payment eligibility purposes, but only one of them may be deemed to be in the trade or business of farming for SE tax purposes.

Note. The case may support an argument that satisfaction of the active engagement test by both spouses does not necessarily create a partnership for tax purposes. However, that is probably a weaker argument because Vianello did not involve a spousal farming situation.

Although Vianello may eliminate the need to make a QJV election in spousal farming situations. However, without the election, it is possible that the IRS could deem spouses to be in a partnership, thereby triggering the requirement to file a partnership return.

SUMMARY The QJV election can be used to simplify the tax reporting requirement for certain spousal businesses that would otherwise be required to file as a partnership. This includes spousal farming operations where each spouse qualifies as a separate person for payment limitation purposes. However, the election does not eliminate SE tax on each spouse’s share of income.

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SESSION SEVEN – 4:15-4:45 p.m. AG DISASTERS AND CASUALTIES

USDA LIVESTOCK INDEMNITY PROGRAM PAYMENTS

Overview Recent wildfires in Kansas, Oklahoma and Texas have resulted in thousands of livestock deaths and millions of dollars of losses to the agricultural sector in those states. There is a program that can help soften the blow – the USDA Livestock Indemnity Program (LIP) and how to report LIP payments. 2014 Farm Bill – The LIP Program The LIP program, administered by USDA’s Farm Service Agency (FSA), was created under the 2014 Farm Bill to provide benefits to livestock producers for livestock deaths that exceed normal mortality caused by adverse weather, among other things. The amount of a LIP payment is set at 75 percent of the market value of the livestock at issue on the day before the date of death, as the Secretary determines. Eligible livestock include beef bulls and cows, buffalo, beefalo and dairy cows and bulls. Non-adult beef cattle, beefalo and buffalo are also eligible livestock. The livestock must have died within 60 calendar days from the ending date of the “applicable adverse weather event” and in the calendar year for which benefits are requested. To be eligible, the livestock must also have been used in a farming (ranching) operation as of the date of death. Contract growers of livestock are also eligible for LIP payments. However, ineligible for LIP payments are wild animals, pets, or animals that are used for recreational purposes (i.e., hunting dogs, etc.). As previously noted, LIP payments are set at 75 percent of the market value of the livestock as of the day before their death. That market value is tied to a “national payment rate” for each eligible livestock category as published by the USDA. For contract growers, the LIP national payment rate is based on 75 percent of the average income loss sustained by the contract grower with respect to the livestock that died. Any LIP payment that a contract grower is set to receive will be reduced by the amount of monetary compensation that the grower received from the grower’s contractor for the loss of income sustained from the death of the livestock grown under contract. As for FSA payment limitations, a $125,000 annual payment limitation applies for combined payments under the LIP, Livestock Forage Program, and the Emergency Assistance for Livestock, Honey Bees and Farm-Raised Fish program. In addition, to the payment limitation, and eligible farmer or rancher is one that has average adjusted gross income (AGI) over a three-year period that is less than or equal to $900,000. For 2017, the applicable three-year period is 2013-2015. For a particular producer, that could mean that tax planning strategies to keep average AGI at or under $900,000 need to be implemented. That could include the use of deferral strategies, income averaging and amending returns to make or revoke an I.R.C. §179 election. An eligible producer can submit a notice of loss and an application for LIP payments to the local FSA office. The notice of loss must be submitted within the earlier of 30 days of when the loss occurred (or became apparent) or 30 days after then end of the calendar year in which the livestock loss occurred. For contract growers, a copy of the grower contract must be provided. For all producers, it is important to submit evident of the loss supporting the claim for payment. Photographs, veterinarian records, purchase records, loan documentation, tax records, and similar data can be helpful in documenting losses. Of course,

197 the weather event triggering the livestock losses must also be documented. In addition, certification of livestock deaths can be made by third parties on Form CCC-854, if certain conditions can be satisfied Tax Reporting Given that the wildfires occurred in the early part of 2017, it is likely that any LIP payments will also be received in 2017. That’s not always the case. Sometimes LIP payments are not paid until the calendar year after the year in which the loss was sustained. For example, livestock losses in South Dakota a few years ago occurred late in the year, but payments weren’t received until the following year. In any event, for LIP payments that are paid out, the FSA will issue a 1099G for the full amount of the payment. Death of breeding livestock. While the 1099G simply reports the gross amount of any LIP payment to a producer for the year, there may be situations where a portion of the payment is compensation for the death loss of breeding livestock. If the producer would have sold the breeding livestock, the sale would have triggered I.R.C. §1231 gain that would have been reported on Form 4797. That raises a question as to whether it is possible to allocate the portion of the disaster proceeds allocable to breeding livestock from Schedule F to Form 4797. This is an issue that many producers that have sustained livestock losses will have. While it is true that gains and losses from the sale of breeding livestock sales are reported on Form 4797, the IRS will look for Form 1099-G amounts paid for livestock losses to show up on Schedule F – most likely on line 4a. Income inclusion and deferral. The general rule is that any benefits associated indemnity payments (or feed assistance) are reported in income in the tax year that they are received. That would mean, for example, that payments received in 2017 for livestock losses occurring in 2017 will get reported on the 2017 return. Likewise, payments for livestock losses occurring in 2016 that were received in 2017 would also be reported in 2017. The receipt and inclusion in income of LIP payments could also put a livestock producer in a higher income tax bracket for 2017. In that instance, there might be other tax rules that can be used to defer the income associated with the livestock losses. Under I.R.C. §451(e), the proceeds of livestock that are sold on account of weather-related conditions can be deferred for one year. Under another provision, I.R.C. §1033(e), the income from livestock sales where the livestock are held for draft, dairy or breeding purposes that are involuntarily converted due to weather can be deferred if the livestock are replaced with like-kind livestock within four years. The provision applies to the excess amount of livestock sold over sales that would occur in the course of normal business practices. While I.R.C. §451(e) requires that a sale or exchange of the livestock must have occurred, that is not the case with the receipt of indemnity payments for livestock losses. So, that rule doesn’t provide any deferral possibility. The involuntary conversion rule of I.R.C. §1033(3) is structured differently. It doesn’t require a sale or exchange of the livestock, but allows a deferral opportunity until the animals acquired to replace the (excess) ones lost in the weather-related event Thus, only the general involuntary conversion rule of I.R.C. §1033(a) applies rather than the special one for livestock when a producer receives indemnity (or insurance) payments due to livestock deaths. Thus, for LIP payments received in 2017, they will have to be reported unless the recipient acquires replacement livestock within the next two years – by the end of 2019. Any associated gain would then be deferred until the replacement livestock are sold. At that time, any gain associated gain would be reported and the gain in the replacement animals attributable to breeding stock would be reported on Form 4797. Conclusion Livestock losses due to weather-related events can be difficult to sustain. LIP payments can help ease the burden. Having the farming or ranching operation structured properly to receive the maximum benefits possible is helpful, as is understanding the tax rules and opportunities for reporting the payments.

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FARM-RELATED CASUALTY LOSSES AND INVOLUNTARY CONVERSIONS

Overview

Farm and ranch property is exposed to weather-related events that can seriously damage or ruin the property. The massive wildfires in parts of Kansas and the horrific pictures have illustrated the devastation that the affected farmers and ranchers have suffered. It’s truly gruesome to see the pictures of dead livestock and the burned-up fences and pastures, not to mention the buildings, structures and homes that were lost. The financial losses are large, but there are some tax provisions that can be utilized to at least partially soften the blow.

Casualty Losses

A casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Casualty losses are deductible regardless of whether the property is used in the trade or business, held for the production of income or held for personal purposes although the rules differ slightly on how the loss is calculated.

Sometimes, the issue in a particular case comes down to drawing a line between what is a casualty and what is ordinary wear and tear. For purposes of this post, a casualty is assumed. The recent Kansas wildfire situation, for example, leaves no doubt that the losses are casualty losses for tax purposes.

The amount of the deduction for casualty losses is the lesser of the difference between the fair market value before the casualty or theft and the fair market value afterwards, and the amount of the adjusted income tax basis for purposes of determining loss. The deduction can never exceed the basis in the item that suffers the casualty. In effect, the measure of the loss is the economic loss suffered limited by the basis (and any insurance recovery).

Here's a simple example:

Assume a rancher has five Hereford cows and one Hereford bull in a pasture. A lightning strike ignites a wildfire, and the wildfire spreads rapidly by high winds and the cows and bull are caught in the fire and are killed. The cows were raised and have a basis of $0.00 and a fair market value of $4,500. The bull, which was purchased for $5,000, had a fair market value of $6,000 at the time of death. The amount of the casualty loss is the difference in the fair market value before and after the loss is $10,500 ($10,500 - $0.00). However, the total basis in all of the animals is only $5,000 - the basis of the bull. Since the deductible loss can never exceed the basis, the amount of the deduction is limited to $5,000.

In addition, any casualty loss must be reduced by any insurance recovery. Thus, returning to the example, if the rancher collected $4,500 of insurance on the dead cattle, the deductible loss would be limited to $500. The deduction is to be taken in the year in which the loss was incurred. It is claimed on Section B of Form 4684 and on Form 4797.

Note: If the rancher’s casualty loss causes his deductions to exceed his income for the year in which he claims the loss, the rancher may have a net operating loss (NOL) for the year of the casualty that is entitled to a two-year carryback and a 20-year carryforward. However, the portion of the NOL arising from the casualty loss has a three-year carryback period. I.R.C. §172(b)(1)(E).

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Involuntary Conversion

What if, in the example above, the rancher’s pasture was destroyed by the wildfire but he had other livestock that survived? But, without usable pasture, the rancher had to sell the livestock. That’s where another tax provision can apply.

When a farmer sells livestock (other than poultry) held for draft, dairy or breeding purposes in excess of the number that would normally be sold during the time period, the sale or exchange of the excess number may be treated as a nontaxable involuntary conversion if the sale occurs because of drought, flood or other weather-related condition. The livestock sold or exchanged must be replaced within two years after the year in which proceeds were received with livestock similar or related in service or use (in other words, dairy cows for dairy cows, for example), and be held for the same purpose that the animals given up were held. Thus, dairy cows can be replaced with dairy cows, but they can’t be replaced with breeding animals.

The tax on the sale is triggered when the replacement animals are sold. If it is not feasible to reinvest the proceeds in property similar or related in use, the proceeds can be reinvested in other property used for farming purposes (except real estate). Similarly, if it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into property that is not like-kind or real estate used for farming purposes. I.R.C. §1033(f).

If the replacement property is livestock, the new livestock must be held for the same purpose as the animals disposed of because of the weather-related condition. Treas. Reg. § 1.1033(e)-1(d). The two-year replacement period is extended to four years in areas designated as eligible for assistance by the federal government (i.e., by the President or any agency or department of the federal government). I.R.C. §1033(e)(2)(A). Presumably, any livestock sales that occur before the designation of an area as eligible for federal assistance would also qualify for the extended replacement period if the drought, flood, or other weather-related conditions that caused the sale also caused the area to be so designated. The replacement property must be livestock that is similar or related in service or use to the animals disposed of. Also, the Treasury Secretary has the authority to extend, on a regional basis, the period for replacement if the weather- related conditions continue for more than three years. I.R.C. §1033(e)(2)(B).

The election to defer the gain is made by attaching a statement to the return providing evidence of the weather-related condition that caused the early sale, the computation of the gain realized, the number and kind of livestock sold and the number and kind of livestock that would have been sold under normal business practices. The election can be made at any time within the normal statute of limitations for the period in which the gain is recognized, assuming that it is before the expiration of the period within which the converted property must be replaced. If the election is filed and eligible replacement property is not acquired within the applicable replacement period (usually four years), an amended return for the year in which the gain was originally realized must be filed to report the gain. But, if the animals are replaced, for the tax year in which the livestock are replaced, the taxpayer should include information with the return that shows the purchase date of the replacement livestock, the cost of the replacement livestock and the number and kind of the replacement livestock. The election must be made in the return for the first tax year in which any part of the gain from the sale is realized. It’s also very important for a taxpayer to maintain sufficient records to support the nonrecognition of gain.

Note: For livestock that are partnership property and are sold by the partnership, the election is the responsibility of the partnership. The partners do not individually make the election to defer recognizing the gain. See Rosefsky v. Comr., 599 F.2d 515 (2d Cir. 1979).

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The Interaction of the Two Rules

Returning to the example above, assume that the rancher received insurance proceeds exceeding $5,000, the net book value of the animals. For instance, if the rancher received $6,000 of insurance proceeds, the $1,000 exceeding the tax basis of the dead animals would be taxable. That is a potential taxable gain that can be deferred if the rancher makes a valid election to defer the gain, and the livestock are replaced within the applicable timeframe. In that instance, the $1,000 casualty gain can be deferred until the replacement animals are sold. However, it may be advantageous from a tax standpoint for the rancher to report the gain on the animals in order to claim ordinary depreciation on the replacement animals.

Another Rule – One-Year Deferral

Under another rule, if farm and ranch taxpayers on the cash method of accounting are forced because of drought or other weather-related condition to dispose of livestock (raised or purchased animals that are held either for resale or for productive use) in excess of the number that would have been sold under usual business practices, they may be able to defer reporting the gain associated with the excess until the following taxable year. I.R.C. §451(e). The taxpayer's principal business must be farming in order to take advantage of this provision. This brings up a key observation – at the time the tax return is due for the year of the casualty, the livestock owner may not be sure of which election is the best one to make. In that event, a “protective” election can be made under I.R.C. §1033 for that tax year. If the livestock can be replaced within the applicable replacement period, the involuntary election can be revoked and the return for the casualty year can be amended to make the election to defer the gain for one year. In that instance, the return for the year after the casualty would also have to be amended to report the deferred gain. Relatedly, a taxpayer can make an election under I.R.C. §451(e) until the four-year period for reinvestment of the property under I.R.C. §1033 expires. That means that if a livestock owner elects involuntary conversion treatment and fails to acquire the replacement livestock within the four-year period, the I.R.C. §451(e) election to defer the gain for one year can still be made. If that happens the livestock owner will have to file an amended return for the casualty year to make the I.R.C. §451(e) election and revoke the I.R.C. §1033(e) election, and the next year to report the gain deferred to that year. Other Points Farming operations organized in a form other than as a C corporation which have received “applicable subsidies” are subject to an overall limitation on farming losses of the greater of $300,000 ($150,000 in the case of a farmer filing as married filing separately) or aggregate net farm income over the previous five- year period. Farming losses from casualty losses or losses by reason of disease or drought are disregarded for purposes of figuring this limitation. I.R.C. §461(j).

Farm income averaging can also be a useful tool as an election in a tax year in which a substantial casualty has been sustained. The interaction of the income averaging election, casualty loss rules, the tax treatment of livestock sold on account of weather-related conditions and loss carryback rules can provide some significant tax planning opportunities.

Conclusion

Sustaining a casualty loss can be extremely difficult for a farmer or rancher, or any other taxpayer for that matter. But, there are tax rules that can be used to soften the blow.

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TREATMENT OF FARMING CASUALTY AND THEFT LOSSES

The Basics

Casualty and theft losses are important because of the exposure of farm property to the elements as well as exposure to those who might steal. The basic first principle is that casualty and theft losses are deductible regardless of whether the property is used in the trade or business, held for the production of income or held for personal purposes although the rules differ slightly on how the loss is calculated.

Casualty Loss

A casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. So, for example, you can’t take a casualty loss deduction for “buyer resistance” to your farm because your neighbor had wind towers put up, or the feds determined that your property has jurisdictional wetlands on it, or it happens to be located near a murder suspect (all actual cases). The issue in a particular case comes down to drawing a line. The line is between what is a casualty and what is ordinary wear and tear. If, for example, a farmer or rancher fails to screw the drain plug into a crankcase and loses all of the oil, or failed to put any oil in the crankcase after draining it and starts down the road, is that a casualty loss or is that ordinary wear and tear when the engine is ruined? In this situation, it really comes down to whether there was willful negligence. If not, then the loss is probably a casualty loss.

In the farm and ranch setting, there are a number of cases involving the improper use of herbicides, flood, frost and freezing, insect damage, drought, fire and wind, all of which are examples of casualty where damage was caused. If the taxpayer can successfully demonstrate that such losses were sudden, unexpected and unusual, the losses will be deductible if the loss was not caused as the result of willful negligence. Losses because of disease or termite damage, for example, are generally not eligible for casualty loss treatment because the loss is progressive rather than sudden. For example, Dutch Elm disease has been repeatedly rejected as a cause of a casualty loss along with most other tree diseases as well.

Theft Loss

Theft, on the other hand, is the criminal misappropriation of property. Theft includes larceny, robbery and embezzlement. In one case, an individual purchased a farm, under a sale contract which specified that the well on the premises was a “good producing water well.” Shortly after the buyer obtained possession of the premises, the well went dry. The buyer argued in court that he had suffered a theft loss because the seller misrepresented the well. The court rejected the buyer's argument, ruling that no theft had occurred. The court ruled that there may have been fraud or misrepresentation but not theft giving rise to a deduction. It is usually quite difficult for an event to be considered a theft unless there has been a criminal taking of property as determined by state law. However, courts will allow a theft loss deduction for investors who were defrauded in a real estate investment scheme.

Theft losses are only deductible in the year of discovery rather than the year that the theft occurred. This fact has proved to be one of the major stumbling blocks in the ability to deduct for losses attributable to theft. Many times, people wait around thinking they will find the item that has come up missing, or that it will be returned, only to discover too late that the property was stolen and is not now deductible. Casualty losses, alternatively, are deductible only in the year the damage occurred.

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Deductible Amount

The amount of the deduction for both casualty and theft losses is the lesser of (1) the difference between the fair market value before the casualty or theft and the fair market value afterwards and (2) the amount of the adjusted income tax basis for purposes of determining loss. Obviously, with theft, the item is gone, so the fair market value afterward is zero. Thus, the deductible theft loss is equivalent to the fair market value of the item immediately preceding the time of the theft. However, the deduction can never exceed the basis in the item. Hence, the loss attributable to theft or casualty is the lesser of the difference of the fair market value before and after or the basis in the item. In effect, the measure of the loss is the economic loss suffered limited by the basis.

A similar principle applies for crops lost immediately before harvest due to a catastrophic event. If the taxpayer deducted the cost of raising the crop, the income tax basis in the crop is zero and the deductible loss is zero. The part that has been through the tax mill once cannot be run through a second time.

For property held for nonbusiness use, the first $100 of casualty or theft loss attributable to each item is not deductible. The deduction is also limited to the excess of aggregate losses over 10 percent of adjusted gross income (unless the loss was a result of certain hurricanes). Since 1983, nonbusiness losses have been deductible only to the extent total nonbusiness casualty and theft losses exceed 10 percent of the taxpayer's adjusted gross income. However, each casualty or theft loss of nonbusiness property continues to be deductible only to the extent the loss exceeds $100.

Personal casualty gains and losses (from non-business property) are netted against each other. If the losses exceed the gains, all gains and losses are ordinary. Losses to the extent of gains are allowed in full. Losses in excess of gains are subject to the 10 percent adjusted gross income floor. All personal casualty losses are subject to the $100 floor before netting. If the personal gains for any taxable year exceed the personal casualty losses for the year, all gains and losses are treated as capital gains and losses. Conclusion Unfortunately, casualty and theft losses are not that uncommon for farmers and ranchers. But, for those that sustain them, the tax rules do allow a recovery through the tax code of some of the value that has been lost.

LIVESTOCK SOLD OR DESTROYED BECAUSE OF DISEASE

Although the loss of livestock due to disease does not frequently occur, when it does, the loss can be large. Fortunately, the Code provides a special rule for the handling of the loss. The rule is similar to the rules that apply when excess livestock are sold because of weather-related conditions.

INVOLUNTARY CONVERSION TREATMENT

Gain Deferral Similar to the drought sale rules, livestock that are sold or exchanged because of disease may not result in taxable gain. If the proceeds of the transaction are reinvested in replacement animals that are similar or related in service or use (for example, dairy cows for dairy cows) within two years of the close of the tax year in which the diseased animals were sold or exchanged, there is no taxable gain.145 Specifically, the

145 IRC §1033(a).

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replacement period ends two years after the close of the tax year in which the involuntary conversion occurs and any part of the gain is realized.146

Under these circumstances, the gain on the animals disposed of is not subject to tax. Instead, the gain is deferred until the replacement animals are sold or exchanged in a taxable transaction. The taxpayer's basis in the replacement animals must be reduced by the unrecognized gain on the disposed of animals that were either destroyed, sold, or exchanged.147

Note. Involuntary conversion treatment is available for losses due to the death of livestock from disease. It does not matter whether there is normal death loss or a disease causes massive death loss.148 In addition, involuntary conversion treatment applies to livestock that are sold or exchanged because they were exposed to disease.149

Gain Recognition Gain is realized to the extent money or dissimilar property is received in excess of the livestock’s tax basis. For cash-method farmers, raised livestock has no tax basis. Therefore, gain is realized upon receipt of any compensation for the animals.150

If there is gain recognition on the transaction, it occurs to the extent the net proceeds from the involuntary conversion are not invested in qualified replacement property.151 The gain (or loss) is reported on Form 4797, Sales of Business Property. A statement must be attached to the return for the year in which gain is realized (e.g., the year in which insurance proceeds are received).152 The statement should include the date of the involuntary conversion as well as information concerning the insurance (or other reimbursement) received. If the replacement livestock are received before the tax return is filed, the attached statement must include a description of the replacement livestock, the date of acquisition, and their cost. If the animals will be replaced in a year after the year in which the gain is realized, the attached statement should evidence the taxpayer’s intent to replace the property within the 2-year period.

Disease is not a Casualty Under casualty loss rules, a deduction can be taken for the complete or partial destruction of property resulting from an identifiable event that is sudden, unexpected, or unusual.153 Livestock losses because of disease generally are not eligible for casualty loss treatment because the loss is progressive rather than sudden. Consequently, casualty loss treatment under IRC §165(c)(3) does not apply.

However, this provision does not apply to losses due to livestock disease.154 Involuntary conversion treatment applies, even though the loss is not “sudden.”155

What is a “Disease”? While a livestock disease need not be sudden in nature for the sale or exchange of the affected livestock to be treated under the involuntary conversion rules, a genetic defect is not a disease.156

146 IRC §1033(a)(2)(B)(i). 147 Treas. Reg. §1.1033(b)-1. 148 Rev. Rul. 61-216, 1961-2 CB 134. 149 Treas. Reg. §1.1033(d)-1. 150 See, e.g., DeCoite v. Comm’r, TC Memo 1992-665 (Nov. 17, 1992). 151 IRC §1033(a)(2)(A). 152 Treas. Reg. §1.1033(a)-2(c)(2). 153 Rev. Rul. 72-592, 1972-2 CB 101. 154 IRC §1033(d). 155 See Rev. Rul. 59-102, 1959-1 CB 200. 156 Rev. Rul. 59-174, 1959-1 CB 203.

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Livestock that consume contaminated feed and are lost as a result can be treated under the involuntary conversion rules.157 In addition, the IRS ruled that honeybees destroyed due to nearby pesticide use qualified for involuntary conversion treatment.158

Definition of Livestock IRC §1033(d) provides that if livestock are destroyed, sold, or exchanged on account of disease, then involuntary conversion treatment applies. The definition of “livestock” under IRC §1231 applies for purposes of involuntary conversion treatment.159 Under Treas. Reg. §1.1231-2, livestock includes cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals. and other mammals. It does not include poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, reptiles, etc.

Environmental Contamination If it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested in non-like-kind farm property or real estate used for farming purposes.160 A communicable disease may not be considered to be an environmental contaminant.161

157 Rev. Rul. 54-395, 1954-2 CB 143. 158 Rev. Rul. 75-381, 1975-2 CB 25. 159 Treas. Reg. §1.1231-2(a)(3). 160 IRC §1033(f). 161 Miller v. U.S., 615 F. Supp. 160 (E.D. Ky. 1985).

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