Estate and Succession Planning
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The Federal Income Tax Consequences of the Receipt of Compensation for the Removal of Commercial Citrus Trees
By Michael D. Minton, Esq.and Christopher R. D’Amico, Esq.
In 1995, the U.S. Department of Agriculture (“USDA”) established a program intended to assist in the eradication of citrus canker in the State of Florida under which eligible owners of commercial citrus groves could, subject to the availability of funds, receive compensation for the removal of commercial citrus trees in an effort to eradicate citrus canker. As many of our readers are aware, as a result of the spread of citrus canker across the state due to the hurricanes of 2004 and 2005, on January 10, 2006 the USDA suspended any future funding of the citrus canker eradication program in the State of Florida. However, it has been reported that the USDA is committed to fully funding the eradication efforts initiated up through January 10, 2006. This article will address the federal income tax consequences of the receipt by a citrus grower of payments under three different scenarios. The first scenario addresses what is commonly referred to as the “cash out” scenario, when the grower will not reinvest the USDA payments into a replacement citrus grove or replacement property of any kind. The second scenario addresses the grower that intends to reinvest in replacement property other than a replacement citrus grove, and the final scenario addresses the reinvestment of the payments into a replacement citrus grove.
I. “CASH OUT” SCENARIO
Commercial citrus growers that suffered an eradication of their citrus trees due to infection or exposure to citrus canker were compensated with two types of payments, (i) a tree replacement payment (or “lost tree payment”) and (ii) a lost production replacement payment (or “lost production payment”). Both the lost tree payment and lost production payment were based upon a maximum amount per acre based upon the variety of trees destroyed. See 7 C.F.R. §§ 301.75-15-301.75-16. The lost tree payments were determined using a payment of $26 per tree up to a maximum of between $2,704 and $4,004 per acre, depending on the variety of trees removed. The lost production payments were based upon a complicated formula that in essence determined the net difference between the present value of the projected estimated return from the variety of trees destroyed (assuming the trees had remained in production) and what the USDA projected would be derived from a replanted grove using a 25 year production life cycle for lime trees and a 36 year production life cycle for all other citrus varieties.
In the event that the grower does not intend to reinvest any of the payments received into replacement property, then the least controversial approach would be to treat the amounts received by the grower for lost production payments as ordinary income subject to the graduated tax rates of the Internal Revenue Code of 1986, as amended (the “Code”). Such amounts may, however, be eligible for income averaging under Code Section 1301.
Code Section 1301 provides that, at the election of an individual engaged in a farming business, any tax imposed under Code Section 1 shall be equal to the taxable income of the taxpayer reduced by elected farm income plus the increase in tax which would result if the taxable income of the taxpayer for each of the three (3) prior years were increased by an amount equal to one-third of the elected farm income. I.R.C. § 1301(a). “Elected farm income” is taxable income attributable to any farming business and includes gains from the sale or other disposition of property (other than land) regularly used in the farming business. I.R.C. § 1301(b)(1)(A). An individual engaged in farming includes a partner in a partnership engaged in the farming business and a shareholder of a S Corporation engaged in the farming business. Treas. Reg § 1.1301-1(b)(1). The term “farming business” means the trade or business of raising or harvesting any agricultural or horticultural commodity, including the raising or harvesting of trees bearing fruit. Treas. Reg § 1.263A-4(a)(4). Essentially, Code Section 1301 accomplishes income averaging by permanently increasing the taxpayer’s income in the three years prior to the year in which the taxpayer received the elected farm income. Therefore, the election to elect income averaging under Code Section 1301 should be taken into account in an overall strategy looking at the possibility that the taxpayer will need to make future decisions regarding income averaging and any effects that the income averaging election would have on the alternative minimum tax liability of the taxpayer.
When one analyzes the lost production payments further, however, one comes to the conclusion that not all of the lost production payments should be recognized as ordinary income, but rather some portion should be eligible for long-term capital gain treatment (similar to arguments that were successfully asserted in the line of cases and Revenue Rulings addressing settlement proceeds received by nursery owners in connection with the application of the fungicide “Benlate”). See, Pennroad Corporation v. Commissioner, 21 T.C. 1087 (1954), acq. 1956-2 C.B. 7, aff’d 228 F.2d 329 (3rd Cir. 1956); Berbiglia v. Commissioner, 10 T.C.M. (CCH) 413 (1951);Rev. Rul. 59-102, 1959-1 C.B. 200; Rev. Rul. 54-395, 1954-2 C.B. 143, Rev. Rul. 75-381, 1975-2 C.B. 25; Rev. Rul. 66-334, 1966-2 C.B. 302; and Priv. Ltr. Rul. 9615041. Generally, the theory is that the lost production payment received far exceeds what the grower could reasonably have expected to receive from the grove for that fruit season or the several succeeding seasons thereafter; therefore, the payment must be for something more than reimbursing the grower for lost income for that season. This analysis is very fact specific and would depend on factors such as the production history of the affected groves, the stage of production that the affected groves were in at the time of the conversion and the total capital impairment suffered by the taxpayer as a result of the eradication of the affected groves.
Any amounts received by the grower for lost tree payments would be received in connection with the sale or exchange of property used in a trade or business (even though, in this event, it would be a forced sale or exchange), and therefore, any gain or loss recognized by the grower upon receipt of the lost tree payments would be determined under Code Section 1231. I.R.C. § 1231(a). Under Code Section 1231, if there is a gain realized by the taxpayer in connection with the receipt of the lost tree payments (i.e., the amount of the lost tree payments received exceeded the taxpayer’s adjusted basis in the trees destroyed), then any such gain would be characterized as a long-term capital gain. Id. In the event that the taxpayer realized a loss in connection with the receipt of the lost tree payments (i.e. the amount of the lost tree payments received was less than the taxpayer’s adjusted basis in the trees destroyed), then the loss would be recognized as an ordinary loss. Id. All gains and losses from the sale of all Code Section 1231 properties for each tax year are netted together, therefore determining whether an individual taxpayer will have a gain or loss under Code Section 1231 will depend upon the total Code Section 1231 transactions in the tax year in question. Id.
Notwithstanding the foregoing, Code Section 1245(a) provides that in the event that Section 1245 property is disposed of (citrus trees are section 1245 property), then the taxpayer will recognize ordinary income to the extent of the depreciation deductions allowed with respect to such Code Section 1245 property. I.R.C. § 1245(a). Despite the characterization of any gain under Code Section 1231 as long term capital gain, Code Section 1245 will recharacterize a portion of that gain recognized upon the receipt of any lost tree payments as ordinary income.
Obviously, if the grower in question is classified as a “C Corporation” for federal income tax purposes, then the grower would not be able to take advantage of any preferential long-term capital gains tax rates discussed above.
II. REINVESTMENT IN OTHER REPLACEMENT PROPERTY
In the event that the grower intends to reinvest the payments into replacement property (other than a replacement citrus grove), then the lost production payments in excess of that portion treated as ordinary income should also be eligible for non-recognition treatment under Code Section 1033 as discussed below.
The lost tree payments received by the grower will be eligible for non-recognition of gain pursuant to Code Section 1033, if the grower uses such proceeds to purchase property which is “similar or related in service or use” or “like-kind” (where the converted property is real property) to the property involuntarily converted. I.R.C. § 1033(a) and §1033(g). Generally, the grower will have a period of (i) two years after the close of the taxable year in which the grower received the eligible payments to acquire property “similar or related in service or use,” or (ii) three years after the close of the taxable year in which the grower received the eligible payments to acquire “like-kind” property. Id. The basis of the property acquired as replacement property pursuant to Code Section 1033 will equal the cost of the replacement property decreased by the amount of any gain not recognized upon the conversion. I.R.C. § 1033(b)(2). Extensions of the replacement periods under Code Section 1033 may be granted by the Internal Revenue Service (“IRS”) if the taxpayer shows that there is reasonable cause for the failure to make the timely replacement. Treas. Reg. § 1-1033(a)-2(c)(3).
In order for replacement property to be considered similar or related in service or use, it must meet the following test: (i) the reinvestment must be made in substantially similar property; (ii) the reinvestment must be a substantial continuation of the prior commitment of the capital, not a departure from it; (iii) the replacement property need not duplicate the converted property, but the character of the investment must not be changed; and (iv) the entire transaction must return the taxpayer, whose enjoyment of property has been interrupted without his consent, as closely as possible to his original position. Maloof v. Commissioner, 65 T.C. 263 (1975). For example, it has been held that the replacement of a cattle farm with prune, apricot and walnut orchards qualifies as replacement property which is similar or related in service or use to the converted property. Rev. Rul. 58-254, 1958-1 C.B. 274. While it appears that any farming business should qualify as similar or related in service or use to a condemned citrus grove under Code Section 1033, the determination of whether replacement property meets the similar or related in service or use test, particularly when the converted property is not identical or in the same line of business to the property condemned, is very fact specific and, in some rulings the results appear contradictory. Therefore, it may be advantageous to seek a private letter ruling from the IRS to be certain of the tax treatment under a specific set of facts.
Under Florida law, it is clear that trees planted in the ground are considered real property and part of the land upon which they grow (until severed from the land), and therefore would be eligible for the three year “like kind” replacement period under Code Section 1033(g). Zaun v. Commissioner, T.C.M. 1975-166; In re Mahon, 1998 WL 953984 (M.D. FL. 1998); and Priv. Ltr. Rul. 8851034. The term “like-kind” refers to the nature and/or character of the property and not its grade or quality and, therefore the kind of real property that can be exchanged under the “like-kind” rules is very broad. Treas Reg. § 1.1031(a)-1(b). The fact that the real property involved is improved or unimproved is not material. Id. For example, commercial property replacing condemned agricultural land has been held to be “like-kind” property. Priv. Ltr. Rul. 8130035. Given the broad nature of the “like kind” rules of Code Section 1033(g), almost any type of real property, including commercial investment real property should qualify as replacement property for a converted citrus grove.
Notwithstanding the foregoing, Code Section 1245(a) provides that in the event Section 1245 property (citrus trees are considered Section 1245 property) is disposed of (whether voluntarily or involuntarily), then the taxpayer will recognize ordinary income (assuming the taxpayer is otherwise realizing a gain on the transaction) to the extent of the depreciation deductions allowed with respect to such Code Section 1245 property. I.R.C. § 1245(a). However, if Code Section 1245 property is disposed of and gain is not recognized in whole or in part under Code Section 1033, and the replacement property includes property which is characterized as Code Section 1245 property, then the amount of gain taken into account under Code Section 1245 shall not exceed the sum of the amount of gain recognized on the disposition (without regard to Section 1245), plus the fair market value of property acquired which is not Code Section 1245 property. I.R.C. § 1245(b)(4). Any unrecognized Section 1245 gain is transferred to the Section 1245 replacement property and will be recognized upon the future sale or conversion of the Section 1245 replacement property. Treas. Reg. § 1.1245-2(c)(4). While it appears that most real property would qualify as like kind replacement property to any converted real property (including converted citrus groves), most buildings or structures on commercial investment real property are classified as Section 1250 property (not Section 1245 property) and, therefore using commercial investment real property as replacement property for a citrus grove would generally not allow the taxpayer to defer the recognition of any Section 1245 recapture income inherent in the converted property. However, with proper planning, it is possible through the use of a properly prepared cost segregation analysis on the proposed replacement property to defer some or all of the Code Section 1245 recapture income, even when the replacement property would normally be classified as Section 1250 property. A cost segregation analysis is simply an engineering study performed on real property that can allow the allocation or reallocation of building or acquisition costs to the building’s (or structure’s) component parts that are classified as Section 1245 property (not Section 1250 property) and, therefore eligible for deferral of gain under Code Section 1033 (or more commonly, eligible for accelerated depreciation).
If the grower that is seeking to take advantage of Code Section 1033 is taxed as a “partnership” for federal income tax purposes and the converted property is encumbered by liabilities, then Code Sections 731 and 752 can create a trap for the unwary (if the partners do not have sufficient basis in their partnership interests). For example, Partnership X operates a commercial citrus grove. Partnership X is owned 50% by Partner A and 50% by Partner B. Each Partner has an adjusted basis in its partnership interest of $250,000. In Year 1, Partnership X suffers a condemnation of its citrus grove and receives a payment of $1,000,000. The Partnership’s adjusted basis in the citrus grove was $500,000 and the grove was encumbered by a $750,000 debt. The partnership realized a $500,000 gain on the condemnation of the grove ($1,000,000 amount realized minus the $500,000 adjusted basis). In Year 1 the Partnership uses $750,000 of the amount realized to pay off the $500,000 debt. In Year 2, within the replacement period under Code Section 1033, Partnership X acquires qualified replacement property paying $250,000 cash and borrowing the remaining $750,000. While Partnership X did not recognize any gain upon the receipt of the condemnation proceeds under Code Section 1033 in Year 1, Partner A and B each did experience a $375,000 decrease in their share of partnership liabilities, which resulted in a constructive distribution under Code Section 752 of $375,000 to each Partner. This constructive distribution under Code Section 752 resulted in each Partner recognizing $125,000 in gain in Year 1 because the constructive distribution under Code Section 752 exceeded each Partner’s adjusted basis in their partnership interests ($300,000 constructive distribution minus $250,000 adjusted basis).
III. REINVESTMENT IN REPLACEMENT CITRUS GROVE
As discussed above, generally, no gain will be recognized by a grower on that portion of the lost production payments, if any, received by the grower that is not treated as ordinary income, if such portion is used to purchase property which is “similar or related in service or use” or “like kind” to the condemned property, subject to the recapture rules of Code Section 1245.
If the grower intends to replant replacement groves on its existing property, the grower will generally have a period of two (2) years to complete the replanting. I.R.C. § 1033(a). Trees which have not been replanted in the ground would not be “like kind” real property and therefore the related or similar use test would apply with its shorter replacement period. If the grower intends to use the eligible payments to purchase any improved or unimproved real property constituting like-kind property, the grower will generally have a period of three (3) years to purchase such like-kind property. I.R.C. § 1033(g). Prior to January 10, 2006, the citrus canker eradication program regulations required a two (2) year quarantine (approval for replanting after one (1) year could be obtained) before replanting of citrus on the affected property. While these quarantine rules were also suspended on January 10, 2006, there still exists a practical limitation on the ability for an affected grower to replant because of the limited availability of healthy nursery trees. Therefore, filing an application for an extension of time to replant with the IRS will most likely be necessary.
Once those funds which qualify under Code Section 1033 for reinvestment have been exhausted, Code Section 263A provides incentives to growers to replant the same type of fruit as were previously grown and allow growers to expense currently the cost of replanting. I.R.C. § 263A(d)(2). While Code Section 263A generally requires the capitalization of the costs incurred to plant a citrus grove and bring it into production, Code Section 263A(d)(2) provides that if plants bearing an edible crop for human consumption were lost or damaged by reason of disease or other casualty, then Code Section 263A shall not apply to any costs of replanting plants bearing the same type of crop (whether on the same land under which such loss or damage occurred or any other land of the same acreage). Id. There is no direct authority that the destruction of healthy trees due to the proximity to a diseased tree meets the requirement of this definition, but one may conclude that this would meet the requirement for the “by reason of disease” requirement. While Code Section 263A(d)(2) will apply to replanting costs incurred with respect to property other than the grower’s existing property that suffered the damage, Code Section 263A(d)(2) only applies to the extent of the acreage of the property that suffered the damage or loss. Treas. Reg § 1.263A-4(e)(1). In addition, Code Section 263A only applies to the “pre-productive period expenses” during the pre-productive period (or the period before the first marketable crop or yield). See TAM 9547002 and Treas. Reg. § 1.263A-4(b)(2)(i). Pre-productive expenses include the costs of replanting, cultivation, maintenance and development of the crops. Id. The costs of the replacement trees are not pre-productive expenses and must be capitalized. Treas. Reg. § 1.263A(d)(3). This preferential expensing of the pre-productive expenses could be available to offset any income recognized from the receipt by the grower of the lost production payments described above.
Code Section 263A(d) also encourages new investors to help finance the replanting efforts. Code Section 263A(d)(2) allow persons other than the grower that owned the property at the time the trees were damaged to currently deduct the costs of replanting and growing out a grove to a productive age, provided that the grower that owned the grove at the time of the destruction continues to own an equity interest of more than fifty percent (50%) in such grove at all times during the taxable year in which the replanting costs are paid or incurred and such other investors (i.e. other than the grower) materially participate in the management of such replacement crops during the taxable year in which the replanting costs are paid or incurred. Id.
While the USDA has suspended any future funding of the eradication of citrus canker through the removal of diseased trees, there still remain a substantial number of growers that have received or will receive lost tree and lost production payments for diseased trees eradicated prior to the suspension of funding by the USDA. Careful analysis and planning will need to be undertaken for such grower’s to determine the tax effect of the receipt of said payments to each grower, particularly where the grower intends to take advantage of Code Section 1033 and Code Section 263A.
