Top 10 Agricultural Law and Taxation Developments of 2014
2015 brings a new year and a look back at the most significant agricultural law and taxation developments of 2014. It’s difficult to narrow the developments down to the “Top 10” with so many to choose from. But, when they are considered in terms of the overall impact on agricultural producers and agricultural businesses, some major ones definitely stand out. 2014 was another illustration, good or bad, of the ever-increasing involvement of the law into the activities of agricultural operations. That is not likely to scale back in 2015. With that much said, the following is my list of what I view as the “Top 10” agricultural law/tax developments of 2014 based on their impact (or potential impact) on U.S. agricultural producers and the sector as a whole.
1. The Impact of Obamacare
Clearly, the biggest development of 2014 is the impact that Obamacare has on all taxpayers, ag not excluded. During 2014 many more taxpayers learned that the claim that “if you like your policy, you can keep your policy” was not true. Indeed, one of the architects of Obamacare got caught on tape admitting that the law deliberately used deceptive language so that “the American public” could be fooled into approving it. Beginning with the 2014 tax returns, all taxpayers will have to certify to the satisfaction of the IRS that they have the mandated level of government-approved health insurance. If not, Obamacare’s penalty tax provisions will have to be accounted for. Many new and complex calculations are associated with 2014 returns along with new entries on the return, proof of exemption from the mandate or, if an exemption does not apply, the calculation and payment of the penalty tax.
It’s not just a simple flat amount for most taxpayers. An additional computation may need to be made for taxpayers who bought their insurance through a government “exchange” because they might be eligible for a “premium assistance tax credit” to offset the cost of the insurance that they bought. That credit can be taken in advance (and goes to the insurance company to lower premium costs to the insured during the year) or claimed with the return and, if taken in advance, another calculation may need to be computed to determine how much, if any, of the credit has to be paid back with the 2014 return.
Beginning in 2014, Obamacare’s impact on health reimbursement arrangements (HRAs) became apparent. HRAs are very popular among farm and ranch operations (and other small businesses), but they could be illegal under Obamacare triggering a penalty tax of $100/day/employee/violation. That’s a $36,500 tax per employee for a plan that is not Obamacare-compliant for the full year. Basically, if an HRA covers two or more current employees, it cannot impose an annual dollar limit on coverage and must provide preventative services without cost-sharing. Ancillary coverage only is allowed for plans covering more than a single employee. So spousal-only plans are permissible, but beyond that, an HRA violates Obamacare and triggers the onerous penalty tax. In addition, IRS and the Department of Labor said in late 2014 that it wasn’t possible to simply “gross-up” wages to make a non-compliant plan compliant. Violators are supposed to self-report their violations to the IRS, and may be able to avoid the penalty tax if a non-compliant plan is eliminated or corrected within a 30-day window.
Relatedly, the practice of reimbursing premiums for the more-than-2-percent shareholders of S corporations was also thrown into doubt. As 2014 ends, we are still waiting for IRS guidance on the issue, but it appears for now that such a practice also runs afoul of Obamacare and subjects the taxpayer to the $100/day/employee/violation penalty tax.
Also during 2014, several different federal courts issued rulings on the availability to taxpayers of the premium assistance tax credit. As noted earlier, Obamacare establishes a premium assistance tax credit to help offset the cost of health insurance premiums. The law also states that the credit is available to anyone who buys health insurance from an exchange "established by the State...".But, the vast majority of states didn’t create exchanges. So, when the Administration realized that many people would not be subject to Obamacare’s penalty tax for not having the mandated government-approved health insurance (because if the credit is not available, health insurance will be more likely to be unaffordable which then exempts the taxpayer from the requirement to get insurance and, hence, creates an exemption from the penalty tax for not having insurance), they instructed the Treasury Department to develop a regulation expanding the availability of the credit to persons buying health insurance through either a state or federal exchange. In 2014, the D.C. Circuit Court of Appeals, in Halbig v. Burwell, 758 F.3d 390 (D.C. Cir. 2014), concluded that the statutory language was clear and invalidated the regulation. Later the same day, however, the Fourth Circuit Court of Appeals upheld the regulation in King v. Burwell, 759 F.3d 358 (4th Cir. 2014). In November, the U.S. Supreme Court agreed to clear up the conflict between the circuit courts. Oral argument is set for March 4, 2015, and a decision is expected by the end of June. The case is a key one, because if the regulation is ultimately struck down, many people will be ineligible for the premium tax credit and won't get hit with a penalty tax for not getting insurance. Furthermore, the employer mandate (which requires employers with more than 50 employees to purchase insurance for their employees or pay a penalty) will not be triggered because employers only become liable for the employer mandate penalty when one of their employees receives a premium tax credit through an exchange. Politicians of all stripes agree that an invalidation of the premium tax credit would likely kill-off Obamacare because it is the linchpin to the entire law.
2. The 2014 Farm Bill
In early 2014, the 2014 Farm Bill passed the Congress and was signed into law. The legislation contains a projected $956 billion in spending over the next 10 years (much of which is attributable to spending on Food Stamps and related programs) which is approximately 50 percent more than the 2008 Farm Bill. The Farm Bill repeals direct payments immediately, repeals seven other current commodity programs and makes adjustments to payment limitations, program eligibility rules and the income limitation rule. Farmers have two options via a one-time irrevocable election with respect to programs designed to replace the ACRE program and direct payments – Agricultural Risk Coverage (ARC) and Price Loss Coverage (PLC). The election can be made on a crop-by-crop basis. If an election is not made for a farm, a default rule applies PLC to the farm. PLC payments are triggered if U.S. average market price for the crop year are less than the crop’s reference price. ARC, on the other hand, makes a payment when the crop revenue of a covered commodity is less than the guarantee for the covered commodity. . For both PLC and ARC, payment acres are pegged at 85 percent of the farm’s base acres for the crop at issue, plus any former cotton base acres planted to the crop. Individual ARC payments are 65 percent of a farm’s total base acres (plus any former cotton base acres). If a producer selects individual ARC (as opposed to county ARC), that choice applies to all commodities on the farm.
The bill replaces the Dairy Product Price Support and MILC programs with the Dairy Production Margin Protection Program effective September 1, 2014. The program is based on the difference between the price of milk and the feed cost of producing milk. A coverage level can be elected in a range between $4 and $8 per cwt in $.50 increments. There is no premium for the lowest level of coverage.
As for payment limits, the 2008 Farm Bill had various caps depending on the type of payment involved. Those caps are replaced with a single payment cap of $125,000 ($250,000 for married couples). Thus, the total amount of payments that an individual or entity can receive either directly or indirectly (except for a joint venture or general partnership) for any crop year is $125,000. Again, spouses are able to double that amount. A separate limit does apply to peanuts, however.
The bill removes both the farm and non-farm AGI limitations of the 2008 Farm Bill and replaces them with a $900,000 AGI limitation applicable to any individual or entity. The $900,000 AGI limitation applies to both commodity and conservation programs. However, the Farm Service Agency does not take into account any I.R.C. §179 deduction for an S corporation or a partnership. They do for a C corporation or an individual.
The bill extends the Conservation Reserve Program (CRP) through 2018, and the maximum acreage that can be enrolled in the CRP drops from 27.5 million acres in fiscal year 2014 to 24 million acres in 2018. Of those amounts, a limit of 2 million acres of grasslands is imposed for all years. The bill also made changes to other conservation programs.
The livestock indemnity program was made permanent, and the bill left the Country of Origin Labeling (COOL) rules intact. Originally, COOL rules went into effect in 2009, but those were found to violate the World Trade Organization’s (WTO’s) trade rules, and the USDA was given until May 23, 2013 to write rules that complied with WTO requirements. Those final 2013 rules imposed more stringent labeling requirements than the original rules and were immediately challenged in court by Canada and Mexico. However, the D.C. Circuit Court of Appeals upheld the constitutionality of the rules in American Meat Institute v. United States Department of Agriculture, No. 13-5281, 2014 U.S. App. LEXIS 14398 (D.C. Cir. Jul. 29, 2014). But, that didn’t satisfy the WTO, which later ruled that the COOL rules discriminated against beef and pork exports from foreign countries (i.e., Canada and Mexico). The USDA has appealed the WTO ruling with a decision expected in 2015. Retaliatory trade sanctions against the U.S. are possible in 2015.
The Farm Bill did not include a provision that was contained in the initial House version that would have barred a state, absent legitimate public safety concerns, from enacting legislation designed to regulate the production of out-of-state agricultural goods and livestock that are sold in that state. The provision was in response to a California ballot initiative the bars California egg producers from confining an egg-laying hen in cages too small to allow the hen to move around. Subsequent California legislation criminalized the sale of eggs for human consumption in California on or after January 1, 2015, if those eggs were the product of egg-laying hens confined in a manner not in compliance with California law no matter where they were produced. The U.S. Supreme Court has long held that one state cannot regulate economic conduct in another state in a manner that is clearly excessive in relation to the benefits to the regulating state, even if the law is facially neutral. In 2014, the Missouri Attorney General (and officials from other states) sued California officials over the law. However, on October 2, 2014, the federal court in California hearing the case dismissed it due to lack of standing. The court said the plaintiffs had not yet been injured by the law. State of Missouri, et al. v. Harris, No. 2:14-cv-00341-KJM-KJN, 2014 U.S. Dist. LEXIS 141337 (E.D. Cal. Oct. 2, 2014). Reports issued late in 2014 indicated that the California law could drive up egg prices by almost 20 percent nationwide in the first half of 2015.
Note: Related to the egg production matter were developments involving animal rights groups and foie gras, a delicacy that is a product of enlarged livers of ducks and geese that have been force-fed corn. While a federal court, in 2013, refused the activist group’s attempt to force USDA to regulate the delicacy as an adulterated food product, the U.S. Circuit Court of Appeals for the Ninth Circuit upheld a California ban on foie gras. In 2014, the U.S. Supreme Court declined to hear the Ninth Circuit case, leaving the California ban in place. Association Des Eleveurs De Canards Et D’Oies Du Quebec, et al. v. Harris, 729 F.3d 937 (9th Cir. 2013), cert. den., 135 S. Ct. 398 ( 2014). Importantly, the California ban only applies to products produced by force feeding a bird to enlarge its liver. It does not ban the sale of duck breasts, down jackets, or other non-liver products from force-fed birds.
New Development: After the Ninth Circuit upheld the California ban, the plaintiffs amended their complaint to include a challenge to the ban on preemption grounds. In early 2015, the district court struck down the California law on the basis that the CA ban was preempted by the Poultry Products Inspection Act, the federal law that regulates the sale and distribution of poultry products. The court pointed out that the plaintiffs had suffered economic injury. Association Des Eleveurs De Canards Et D'oies Du Quebec, et al. v. Harris, No. 2:12-cv-5735-SVW-RZ (C.D. Cal. Jan. 7, 2015).
3. EPA “Water of the United States” Proposed Rule
In a move that could potentially impact nearly all farms and ranches in the U.S., on March 25, 2014, the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (Corps) released a proposed rule defining “waters of the United States” under the Clean Water Act (CWA) (79 Federal Register 22188-22274, April 21, 2014). If enacted, this proposed rule would likely significantly expand the current scope and coverage of the CWA. Generally, the CWA prohibits the discharge of any pollutant or fill material into “waters of the United States” without a permit. The Corps issues permits for the discharge of fill material, and the EPA issues permits for the discharge of pollutants. Persons who discharge pollutants or fill material without obtaining a permit (an often expensive and lengthy process) are subject to civil and criminal penalties. Because the CWA regulates “waters of the United States,” the definition of this phrase defines the statute’s reach. If, for example, a wetland qualifies as “waters of the United States,” its owner may not deposit fill material into that wetland without a permit. If, however, the wetland does not fall into that definition (or if the owner’s activity falls under a specific CWA exemption), no such restrictions exist. The last such U.S. Supreme Court opinion to consider the definition of “waters of the United States,” Rapanos v. United States, 547 U.S. 715 (2006), determined that the Corps’ application of the definition was too broad. Rapanos, however, was a plurality decision in which a majority of Supreme Court justices could not agree on a single rationale.
After Rapanos, the Corps and the EPA issued joint guidance attempting to implement the Supreme Court’s directives. Under this guidance, the agencies asserted CWA jurisdiction over all traditional navigable waters, wetlands adjacent to these waters, relatively permanent tributaries of traditional navigable waters, and wetlands abutting such tributaries. They also claimed jurisdiction over non-permanent tributaries and their adjacent wetlands if they had a “significant nexus” to traditional navigable waters. Finding implementation of this guidance “confusing” and “unpredictable,” the agencies set forth their proposed definition of “waters of the United States” to “clarify” the types of waters that the CWA could cover.
Under this proposed definition, the CWA would apply to: (1) waters which have been or ever could be used in interstate commerce and (2) all interstate waters and wetlands. Additionally, the CWA would apply to (3) all “tributaries” of these interstate waters, (4) all waters and wetlands “adjacent” to these interstate waters, and (5) all waters or wetlands with a “significant nexus” to these interstate waters. “Tributaries” is broadly defined to include natural or man-made waters, wetlands, lakes, ponds, canals, streams, and ditches if they contribute flow directly or indirectly to interstate waters. Importantly, the proposed rule has no requirement that these waterways continuously exist or have any nexus to traditional “waters of the United States,” as is required under current guidance.
In perhaps the most expansive language of the proposed rule, “adjacent” is defined to include “bordering, contiguous or neighboring” waters. Under this definition, all waters (not just wetlands) within the same riparian area or flood plain of interstate waters would be “adjacent” waters subject to CWA regulation. Under the proposed “significant nexus” test, “similarly situated” waters are evaluated as a “single landscape unit.” As such, the proposed regulations would appear to allow the agencies to regulate an entire watershed if one body of water within it has a “significant nexus” to interstate waters. The proposed definition does specifically exclude certain artificially irrigated areas; artificial lakes or ponds used for stock watering, irrigation, or rice growing; artificial swimming pools; small ornamental waters created for primarily aesthetic reasons; and water-filled depressions incidental to construction activity. Although the proposed rule retains existing Clean Water Act exemptions for “normal farming” activities and specifically exempts 56 additional conservation practices, the breadth of the proposed rule’s language raises a number of concerns regarding the potential impact of these proposed regulations on farmers. Exactly how the agencies would apply these rules is unknown. For instance, many of the identified conservation practices involve common ag practices (e.g., building and/or maintaining a fence), could end up being subjected to additional standards. Because these practices were identified in an “interpretive rule” combined with a Memorandum of Understanding between the EPA, Corps and USDA without public comment, it is possible that the standards for the identified practices could change or the practices could be eliminated from the permit exemption.
The Omnibus Spending Bill that was signed into law on December 16, 2014 (Pub. L. No. 113-235), directs the EPA to withdraw the interpretive rule. However, as noted above, the interpretive rule is merely guidance. It is not part of the actual proposed rule that was published in the Federal Register. The Congress, in the Omnibus Spending Bill, did nothing that would impair or negate the proposed rule.
4. GMO Developments
2014 was marked by numerous developments associated with genetically modified organisms (GMOs) that have the potential to impact agricultural producers nationwide. One of those developments involved China’s rejection of Syngenta’s Agrisure Viptera, a GMO corn product. Syngenta develop the corn seed with the MIR162 insecticidal trait. Syngenta promoted MIR162 as the first trait stack-labeled for control of “true armyworm.” After U.S. regulators approved Agrisure Viptera in 2010, Syngenta began selling the GM seed for planting in the 2011 crop year. Most U.S. trading partners—including Canada, Japan, Argentina, and the European Union—also approved the GM trait. China, however, did not grant import approval, despite receiving the initial application from Syngenta in March of 2010. It was during this same period that the Chinese market for U.S. corn exploded. During the 2010-2011 trade year, China imported 979,000 metric tons of corn from the United States. This was comparable to the 950,000 metric tons Canada imported during the same year. One year later, however, China imported 5.2 million metric tons of corn from the U.S., as compared to Canada’s 870,000. Japan remained the largest importer with annual imports of 14.9 million metric tons of U.S. corn. Complicating matters and fueling a contentious climate was the precipitous drop in corn and soybean prices accompanying this same time period. The average price of corn per bushel has dropped by more than half since the summer of 2012. Soybean prices have also declined, although not as dramatically. Although all of the precise reasons for this decline are unknown, it is generally accepted that the record harvest from last year, coupled with the expected record harvest this year, have created a climate where supply has simply outpaced demand. Many have argued that China’s rejection of unapproved GM corn is another important factor. They cite an 85 percent decline in Chinese imports of U.S. corn since November of 2013 as support for their claim.
Syngenta has been hit with a barrage of lawsuits claiming that Syngenta caused significant financial damage to U.S. farmers and exporters due to its release of MIR162 seed into the market before China had approved it for import.
Although China has always publicized a zero-tolerance policy regarding imports of unapproved GM corn (reserving the right to reject an entire shipment of corn if it contains traces of unapproved GM seed), it was not until November 2013, that China began actually rejecting U.S. corn shipments containing traces of Agrisure Viptera. Since that time, China has continued to reject shipments of U.S. corn, as well as shipments of dried distillers grain used in the production of animal feed. Although the GM corn at issue comprised only three percent of U.S. corn production, China has rejected any shipments containing trace amounts of the MIR162 trait.
These legal actions raise a number of important questions, with many implicating U.S. sovereignty. For example, should a country such as China wield regulatory power over the products companies can sell in America? Is compliance with U.S. law sufficient or can foreign countries dictate production requirements? What if these production requirements are rooted in pure economic interest (as is likely the case with China)? Who should bear the risks inherent in a global marketplace?
Another interesting twist to these lawsuits, including a class action suit brought by corn farmers, is that the plaintiffs are not generally opposed to GMO technology. In fact, many have and will continue to profit from its development. Nonetheless, it is difficult to see how these lawsuits will not have a chilling effect on GMO development. The allegations in the complaints are similar to concerns often voiced by GMO opponents. For example, the complaints allege that Syngenta’s development of Viptera constituted an “ultra-hazardous or abnormally dangerous activity” for which it should be held strictly liable. They also assert interesting “trespass to chattels” claims, alleging that MIR162 has led to a “market-wide” contamination and “public nuisance” claims arguing that the public was deprived of its freedom to “choose to purchase and consume” “non-contaminated” corn. Even within its negligence claims, the plaintiffs assert the “near certainty of cross-pollination” and “commingling” as risks that Syngenta should have foreseen. Syngenta has said publically that the complaints are “without merit” and that it “strongly upholds the right of growers to have access to improved new technologies that can increase both their productivity and their profitability.” Syngenta has also stated that it “commercialized the trait in full compliance with regulatory and legal requirements” and has been “fully transparent” in its dealings.
It remains to be seen how these legal battles will unfold. Important legal principles may be established to guide the development and dissemination of emerging food technology. In the short term, however, it seems unlikely that any clear winners will emerge.
Update: On December 17, 2014, Secretary of Agriculture Tom Vilsack announced that China has approved Agrisure Viptera for import. China has not, however, approved the import of Agrisure Duracade. In response to the pending approval, Syngenta and Bunge North America agreed to dismiss Syngenta's pending lawsuit against Bunge. It does not appear, however, that the approval of Viptera will prompt litigants to immediately dismiss the remaining pending lawsuits against Syngenta. In fact, after the announced approval, more lawsuits against Syngenta were filed.
Relatedly, in 2014, several cities and counties enacted or attempted to enact GMO bans. An attempt was made in Los Angeles by the City Council, but then they backed-off. GMO bans were also enacted in Maui, Hawaii, and in Hawaii County (the Big Island). Monsanto challenged the bans and late in 2014, a federal court struck the Hawaii County ban as being preempted by state law. However, the court held that federal law does not bar states or counties from regulating biotech crops in situations where the USDA retains jurisdiction. That could be an important point moving forward.
GMO labeling also continued to be an issue in 2014. As of the end of 2014, Vermont, Maine and Connecticut had enacted statewide GMO labeling laws. The Vermont law is being challenged in court, and the Maine and Connecticut laws are not effective until neighboring states enact similar laws. In the fall 2014 elections, voters in both Colorado and Oregon rejected labeling laws. During 2015, Congress may approve federal legislation that would preempt state labeling laws by prohibiting states from requiring GMO labels on products that are shipped in interstate commerce.
5. Eighth Circuit Reverses the U.S. Tax Court on the Self-Employment Tax Treatment of CRP Payments
Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014), rev’g., 140 T.C. 350 (2013)
On June 18, 2013, the U.S. Tax Court agreed with the position of the IRS announced in an IRS CCA issued in 2003 and a 2006 Notice of Proposed Rulemaking in holding that Conservation Reserve Program (CRP) payments are subject to self-employment tax in the hands of a non-farmer. The Tax Court ruled that a passive landowner’s CRP rental income was subject to self-employment tax. The taxpayer resided in Texas and inherited South Dakota farmland. He also bought farmland from other heirs. He hired a local farmer to farm the land before the land was placed in the CRP three years later. The local farmer maintained the land consistent with the CRP contract. Six years later, the taxpayer moved to Minnesota, but still never personally engaged in farming activities. The taxpayer reported the CRP income on Schedule E where it was not subject to self-employment tax. The Court found the existence of a trade or business based on either the taxpayer’s personal involvement with the CRP contract or through the local farmer that the taxpayer hired to farm the land. The Tax Court stated that the taxpayer was in the business of maintaining an “environmentally friendly farming operation” and also found persuasive the fact that the taxpayer participated in the CRP with a profit intent.
On October 10, 2014, the U.S. Court of Appeals for the Eighth Circuit reversed in a 2-1 opinion. The court noted that the longstanding position of the IRS was that land conservation payments made to non-farmers (including both Soil Bank and CRP payments) were not subject to self-employment tax and that the IRS was bound to that position, particularly because the IRS did not issue the revenue ruling in 2006 that would have formally changed the agency’s position. As such, the court reasoned, the CCM issued in 2003 in which the IRS asserted self-employment tax on all CRP payments and the 2006 Notice of Proposed Rulemaking were not entitled to deference. In addition, the court also viewed the CRP payments that the taxpayer received as being for the use and occupancy of his land, noting that the CRP contract reserves the government’s right of entry on the land. The court noted that, via a CRP contract, the government is using the taxpayer’s land for the government’s own purpose of removing sensitive cropland from production and other environmental purposes for the public’s benefit. Consequently, the court concluded that the CRP payments were “consideration paid [by the government] for use [and occupancy] of [Morehouse’s] property and thus constituted rentals from real estate fully within the meaning of I.R.C. §1402(a)(1). ”The court distinguished a Sixth Circuit’s decision in 2000 on the basis that the taxpayer in Morehouse was not a farmer and that the taxpayer in the Sixth Circuit case was an active farmer.
A dissenting judge disagreed with the majority’s broad construction of “occupancy” for purposes of the rental real estate exclusion, but did point out that, in the dissent’s view, CRP payments paid after 2007 (the effective date of the 2008 Farm Bill provision) are “rental payments.” Under that view, the only question for CRP payments paid post-2007 is whether the recipient is materially participating (either personally or via a tenant) in a farming operation.
Technically, the court’s holding is limited in its application to CRP rents paid before 2008 to a non-farmer that is not receiving Social Security. But, for payments made after 2007 to taxpayers in the Eighth Circuit (AR, IA, MN, MO, ND, NE and SD), the court’s opinion will make it very difficult, if not impossible, for the IRS to argue that CRP rents in the hands of a non-farmer are subject to self-employment tax. ~~The court’s opinion also bolsters the argument that CRP payments paid to a farmer where there is no nexus between the CRP ground and the farmer’s farming operation are not subject to self-employment tax.
6. Issues Surrounding the Use of Unmanned Aerial Vehicles (a.k.a. Drones)
Another issue that rose significantly in importance in 2014 concerns the use of drones on farms and ranches. Drones, like other aircraft, are regulated by the Federal Aviation Administration (FAA). The FAA has taken the position that it is illegal to fly nearly all commercial drones. In recent publications, the FAA has contended that “commercial operations are only authorized on a case-by-case basis.” Currently, the only approval the FAA is granting for the use of commercial drones is an “experimental airworthiness certificate” to conduct research and development, training, and flight demonstrations. Commercial drone operations must have certified aircraft and pilots, in addition to their operating approval. The FAA also allows public entities such as federal and state governments and public universities to apply for a Certificate of Authorization (COAs). Under COAs, governments have used drones in limited operations such as search and rescue, military training, border patrol, and firefighting.
The FAA’s ban on commercial drones applies to the myriad agricultural uses of drones such as crop scouting, disease monitoring, precision spraying, and livestock tracking. Real estate companies have also begun using drones to assist in the marketing of agricultural land. These commercial uses of drones are often justified on the basis that the use falls within an FAA exception for “model aircraft.” However, with the 2012 FAA Modernization and Reform Act (the “Reform Act”), the Congress defined “model aircraft” as unmanned aircraft flown “within the visual line of site of the person operating the aircraft for hobby or recreational purposes.” Earlier, in 1991, the FAA had set forth voluntary guidelines for those flying model aircraft. These guidelines included flying below 400 feet, 3 miles from the airport, and away from populated areas. In a 2007 Notice, the FAA specifically stated, “You may not fly a [UAV] for commercial purposes by claiming that you’re operating according to the Model Aircraft guidelines.”
On June 18, 2014, the FAA issued a notice removing any doubt as to where the agency stands with respect to the classification of drone use in agriculture. In its “Interpretation of the Special Rule for Model Aircraft,” the FAA states that “Determining whether crops need to be watered that are grown as part of commercial farming operation” would not be a hobby or recreational use falling under the model aircraft exception to FAA rulemaking. In contrast, “viewing a field to determine whether crops need water when they are grown for personal enjoyment” would, under the FAA notice, qualify as a “hobby or recreation” flight.
In the Reform Act, Congress instructed the FAA to issue regulations for the “safe integration” of drones into the airspace by September 30, 2015, but the FAA initially stated that they would issue proposed regulations by the end of 2014. These regulations, which will govern unmanned aircraft weighing less than 55 pounds, will most certainly include provisions for commercial operations. It is also expected that they will specifically address and allow certain agricultural uses. As of the end of 2014, it appeared that the proposed regulations would be issued in early 2015. Even so, it will likely be two to three years before the regulations are finalized. Given the potential economic benefits that are lost due to the ban on the use of drones for commercial purposes (some estimates peg it at $10 billion annually), 2015 may see Congress address the issue by, perhaps, integrating drones in to U.S. aviation system.
Although the authority to regulate airspace and airworthiness rests with the federal government, not the states, states may regulate the aeronautical activities of their own institutions and departments. As of the end of 2014, about 25 percent of the states had enacted laws restricting in various fashions the use of drones. This “patchwork quilt” type of state regulation could become problematic when/if the FAA decides to allow certain uses of drones that are illegal under state law. That’s another reason for Congress to take action.
7. IRS Signals Intent to Subject Income of Passive Members of LLCs To Self-Employment Tax
C.C.M. 201436049 (May 20, 2014)
The Limited Liability Company (LLC) entity structure first emerged in Wyoming in 1977. Since that time, all states have enacted statutes authorizing LLCs, and they have become a very popular entity choice for businesses in many industries, including agriculture. Perhaps the primary reason for their popularity is that they provide for the pass-through tax treatment of a partnership with the limited liability of a corporation. They also can provide a self-employment tax advantage over an S corporation (the self-employment tax is 15.3 percent plus, as a result of Obamacare, an additional 0.9 percent if self-employment income exceeds certain levels) and be a useful entity to avoid or substantially minimize the impact of the 3.8 percent tax on passive sources of income – another tax created by Obamacare. But, in late 2014, the IRS took the position that the distributive share of income allocated to LLC members is subject to self-employment tax.
For LLCs, the self-employment tax treatment of income flowing to an LLC member that operates the business has always been a bit unclear. To the extent an LLC owner received a guaranteed payment for services, that amount is subject to self-employment tax. Conversely, I.R.C. §1402(a)(13) says that the distributive share of partnership income of a limited partner (except for guaranteed payments) is not self-employment income. But, that statute was enacted before LLC’s came on the scene. In an LLC, all members have limited liability (just like a limited partner in a limited partnership), so the question became whether I.R.C. §1402(a)(13) meant that all LLC members escaped self-employment tax on their distributive shares except to the extent of any guaranteed payment received. In 1997, the Treasury Department proposed rules that said that an LLC member would owe self-employment tax on their distributive share if (1) they have personal liability for the debts or claims against the entity by reason of being a member; (2) they have the authority under state law to contract on behalf of the entity, or; (3) they participated in the entity’s business activities for more than 500 hours during the entity’s tax year. But, the proposed regulations were never finalized because of accusations that the IRS was creating a “stealth” tax.
The Tax Court, in Renkemeyer, et al. LLP v. Comr., 136 T.C. 137 (2011), a case involving members of a law firm structured as an LLC where all of the law firm’s revenue came from legal services of the lawyer-members, said that the distributive shares of the members were subject to self-employment tax. That’s not a big surprise for a professional services firm that had only a single class of interests – and also explains why many professional businesses are S corporations. S corporations only pay self-employment tax on the amount of reasonable salary that is paid. In 2012, the federal district court in Riether v. United States, 919 F. Supp. 2d 1140 (D. N.M. 2012) said that even though members of the LLC received a salary their distributive share was still subject to self-employment tax. In addition, the court said that the I.R.C. §1402(a)(13) exception did not apply because the LLC members were not members of a limited partnership and didn’t resemble limited partners so it was immaterial whether they were active or passive in the LLC’s business.
Now the IRS Chief Counsel’s Office has followed up on those two court cases by saying that the members of an investment management company structured as an LLC owed self-employment tax on their distributive shares (after reduction for wages and guaranteed payments) even though the LLC treated each member as a limited partner for self-employment tax purposes. The LLC had previously been an S corporation that didn’t pay self-employment tax on distributions beyond reasonable compensation paid, but the IRS said that the LLC couldn’t take advantage of the S corporation rules.
The IRS position doesn’t necessarily mean that distributive shares of all LLC members will get hit with self-employment tax, but if the LLC members provide services to the LLC and the lion’s share of the LLC income is tied to those services, the IRS will hit those distributive shares with self-employment tax regardless of how the LLC characterizes the LLC member’s interest. The IRS position places even greater emphasis on structuring LLCs as manager-managed with two classes of membership so as to minimize self-employment tax liability and liability for the additional 3.8 percent tax on passive income sources under Obamacare. But, plain-vanilla LLCs (and there are a lot of these in agriculture) need to take note of the what the IRS has said. This is a signal that IRS is looking at the issue anew after 17 years of relative silence. Perhaps the Congress will chime in.
8. IRS Position On How Passive Loss Rules Apply To Trusts Shot Down
Frank Aragona Trust v. Comr., 142 T.C. No. 9 (2014)
A significant proportion of farming businesses in the U.S. have been held in the same family for many years. A lot of that same farmland is rented. For these families (and some others) a popular estate planning vehicle for the ownership of that land used in the business is a trust. Sometimes farm businesses, however, lose money. But an IRS interpretation of the passive loss rules contained in I.R.C. §469, has operated to bar trusts from being able to fully deduct losses related to the farming business. Losses from passive activities can only be deducted against income from passive activities.
Under the passive loss rules, an activity is considered to be a passive activity, and the passive loss rules are invoked, if the activity involves a trade or business and the taxpayer does not materially participate in the activity “on a basis which is regular, continuous and substantial.” The rules establish ways in which material participation can be satisfied, and rental activities are always deemed to be passive unless the taxpayer is a real estate professional (a person who puts in at least 50 percent of their working hours in rental activities in which they materially participate for at least 750 hours during the tax year). So, in order to deduct losses from trade or business activities, a “taxpayer” must materially participate in the activity. In other words, the taxpayer must be involved in the business activity on a regular, continuous and substantial basis. That’s a tough test for many individual taxpayers to meet. While the IRS regulations set forth several material participation tests for individual taxpayers, the IRS has never issued regulations addressing the material participation requirement for non-grantor trusts (as well as estates). Thus, while the statute is clear that a trust (rather than a trustee) is the taxpayer whose material participation is decisive, the statute is silent on how to determine if the test has been satisfied. In other words, since the trust can only act through other people to satisfy the material participation test, who are the key other people whose activity counts? The longstanding IRS position has been that only the trustee of a trust acting in their capacity as trustee can satisfy the material participation test. While that position was rejected by a federal court in 2003, the IRS has continued to maintain its position with pronouncements in 2007, 2010 and 2013.
But, in 2014, the Tax Court ruled against the IRS on its position that a trust could not be a “taxpayer” for purposes of the real estate professional exception to the passive loss rules, held that the activity of the employee-trustees of a wholly-owned LLC counted, and implied that the conduct of a trust’s non-trustee employees also count for purposes of the material participation test under the passive loss rules. In the case, a father formed a trust for his five children who were also trustees along with an independent trustee. Three of the kids were also employed by an LLC which the trust fully owned. Two of these three kids also partially owned other LLCs in which the trust held majority ownership. The trust incurred substantial losses in its rental real estate activities which, under the loss carryback rules, were carried back to earlier years to generate tax refunds. The IRS disallowed the losses because they said a trust can’t materially participate in rental activities. But, the Tax Court was convinced that the trust could materially participate in the rental activities through the activities of the trustees as employees and would avoid the passive loss rules if enough time was spent in the rental activities – which it was. The court even implied that the activities of non-trustee employees would count toward the material participation test.
The court’s decision means that for farming operations that are conducted on farmland that has been put into a trust, the material participation test can be satisfied by the trustee acting in its capacity as an employee of the business, and any resulting losses would be fully deductible. While the court’s decision won’t be of help to farmland in trust that is cash rented, it’s a big help where there actually is a farming business being conducted. It also means that it’s much less likely that the 3.8 percent tax on passive sources of income added by Obamacare for years beginning after 2012 will apply (for 2015, the tax applies to trust income exceeding $12,300).
9. Valuation and Discounting Issues
Estate of Elkins v. Comr., 767 F.3d 443 (5th Cir. 2014), aff’g. in part and rev’g. in part, 140 T.C. 86 (2013) and Estate of Giustina v. Comr., No. 12-71747, 2014 U.S. App. LEXIS 22961 (9th Cir. Dec. 1, 2014)
A key estate and gift tax planning concept for practically all farms and ranches of significant size involves structuring the business operation and planning the potential estate for significant valuation discounts for tax purposes. Because family farming operations are typically privately held, discounts are available for minority interest and lack of marketability. In addition, a fractional interest discount may also be available for co-owned property. The key to achieving a discount, however, is in the proper valuation of the interest involved. Two federal court cases late in 2014 show how difficult it can be for courts to deal with the valuation issue. In the Fifth Circuit case, the valuation of co-owned artwork in a decedent’s estate was at issue. The artwork was subject to a co-tenancy agreement requiring unanimous consent before any of it could be sold. There was no right for a co-tenant to seek a partition. The decedent’s estate took a 44.75 percent valuation discount from the fair market value of the artwork, but after being challenged by the IRS which claimed that no discount should be allowed, the estate claimed a 67 percent discount when the case got to the Tax Court. The estate’s argument was that a willing buyer would insist on a substantial discount. While the Tax Court ignored the restriction on a co-tenant to seek a partition, they allowed a 10 percent discount to reflect the difficulty in marketing the artwork. On appeal, the Fifth Circuit reversed, entitling the estate to a refund of over $14 million plus interest, pointing out that the IRS didn’t offer any evidence of the proper discount, and stating that the Tax Court “inexplicably veers off course.”
The valuation (not discounts) of a 41.128 limited partnership interest in a forestry operation was at issue in the Ninth Circuit case. The Tax Court determined that there was a 25 percent chance that the partnership would be liquidated. Thus, the Tax Court weighted by 75 percent the $52 million value of the partnership determined under the cash flow (going concern) method. The other 25 percent weight was applied to a $151 million partnership value pegged by the asset value method. Both methods are used by appraisers to value property for estate and gift tax purposes. The Tax Court apparently came up with these splits on an ad-hoc basis because there wasn’t any evidence that the forestry business would be sold or liquidated. Instead the Tax Court assumed that the owner of the limited partnership interest being valued could combine with the other limited partners and come up with enough of the vote to ultimately dissolve the partnership and trigger a sale or liquidation. On appeal, the Ninth Circuit reversed, noting that the Tax Court’s had engaged in “imaginary scenarios” contrary to evidence. Instead, the court noted that the proper approach was to value the partnership interest on the assumption that the existing limited partners that owned two-thirds of the partnership would seek dissolution. The case was remanded for a recalculation of the proper discount.
The cases point out that valuation issues are difficult, even for the courts, and that to get the sizable tax savings from discounting, qualified experts must be hired and the IRS must do its own valuation analysis with its own experts. This all requires a lot of pre-planning, but proper valuation and discounting can help maintain a farming operation in the family for years to come. That’s a major point as long as the federal estate tax remains in place.
10. Legal Issues Associated With Precision Technology
This issue could be higher on the list next year because it appears to have just started to gain momentum in 2014. With precision technology, ag producers transmit business and production data to agriculture technology providers (ATPs). This data includes, for example, information about planting, production, and harvesting practices. The ATPs then use the data to provide information to the ag producers for use in planting decisions and the use of inputs. Basically, the process is supposed to make the farming operation more efficient. But, the process does raise a number of legal issues that the legal system will eventually have to resolve. A major issue involves ownership of the data. Multiple persons/entities could have an interest in the data. Clearly the landowner would have an economic interest, but so does a tenant, a cooperative, as well as the ATP. So, clearing up who owns the data and can grant permission for its use is a major issue. How the data is used and who can use it will also be issues that will have to be sorted out, along with the type of notice required to be given to the data owner for the data's use. Other important issues include data security and privacy. Could, for example, environmental groups, acquire a specific farm's data regarding pesticide usage?
It is anticipated that many of these (and other) issues will be handled via contractual arrangements, which will include data privacy agreements. Such contracts should include detailed provisions involving services and features, ability of the owner of the data to retrieve it, whether the data can/should be destroyed, and provisions dealing with unauthorized access. Also, such agreements will likely contain language barring data from being used for commodity transactions that violate market speculation rules. In late 2014 , a consortium of farm groups and ATPs published a non-binding set of "privacy and security principles for farm data." The principles state that farmers own the information generated on their farms, but that it is their responsibility to agree upon data use and sharing with other stakeholders, such as tenants and the ATP. As 2015 unfolds, it seems likely that more important developments regarding the use and security of precision agriculture data will unfold. In the meantime, farmers should read all data and security policies carefully and be fully aware of any rights they are relinquishing.