Dean, Mead, Minton & Zwemer
1903 South 25th Street, Suite 200
P.O. Box 2757 (ZIP 34954)
Fort Pierce, Florida 34947
Orlando
Fort Pierce
Viera
772-464-7700
772-464-7877 Fax
www.deanmead.com
MICHAEL D. MINTON
772-464-7700 x. 6701
mminton@deanmead.com
September 2006
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. §§ 301.7515-301.75-16. 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 onethird 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. 75381, 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). Preproductive 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.