In re Hemann

IN RE: NORBERT ALFRED HEMANN, Debtor.

Bankruptcy No. 11-00261

UNITED STATES BANKRUPTCY COURT FOR THE NORTHERN DISTRICT OF IOWA

Dated: April 3, 2013

Chapter 12

ORDER RE: CONFIRMATION OF AMENDED

CHAPTER 12 PLAN

This matter came before the Court on May 10, 2012, and July 2, 2012, for hearings on confirmation of Debtor's First Amended Chapter 12 Plan of Reorganization (Doc. 59). Attorney Joseph Peiffer represented Debtor Norbert Hemann. Carol Dunbar appeared as Chapter 12 Trustee. Attorney Martin McLaughlin appeared for the United States on behalf of the Internal Revenue Service ("IRS"). Attorney John Waters appeared for the Iowa Department of Revenue ("IDOR"). After the presentation of evidence and argument, the Court took the matter under advisement. This is a core proceeding under 28 U.S.C. § 157(b)(2)(L).

STATEMENT OF THE CASE

Debtor's Chapter 12 Plan of Reorganization proposes to treat certain Federal and Iowa taxes as unsecured claims under 11 U.S.C. § 1222(a)(2)(A). The IRS andIDOR object. They assert Debtor is not a family farmer eligible for relief under Chapter 12. They also argue the taxes, which arise from Debtor's sale of an interest in a farm partnership, are not subject to treatment under § 1222(a)(2)(A). The Court concludes Debtor is eligible for Chapter 12 relief and the tax debts fall within the scope of § 1222(a)(2)(A). Debtor's Chapter 12 plan is confirmable.

FINDINGS OF FACT

Debtor Norbert Hemann, age fifty-six, grew up on a farm and started farming with his father in 1974. In 1988, Debtor and his younger brother Andrew Hemann took over for their father and started farming together. Debtor and Andrew continued farming together when they formed the Hemann Brothers Partnership in November 1993. Each held a 50% interest. The farm partnership owned the livestock and machinery the two brothers used in farming. The individual partners signed up for separate government farm program payments. Debtor and Andrew divided the farm labor equally between them. Both of them milked cows and baled hay. Debtor prepared fields, hauled grain, and ground the feed. Andrew ran the combine and the planter. The two brothers farmed more than 300 acres on leased land and split the field work in half as much as they could.

Eventually, Debtor decided to down-size his farming operation. Debtor and Andrew entered into a Dissolution Agreement to end their farm partnership onOctober 15, 2010. (Debtor's Ex. G.) According to the Agreement, the net worth of the farm partnership was $187,319.00. Assets included crops, livestock, machinery, and titled vehicles. Liabilities included loans, a repair bill, a feed account, farm rent, and additional payables. Debtor and Andrew agreed that Debtor would retain an IH 350 tractor, a generator, and a 1997 Chevy 1/2 ton pickup. Andrew retained the remainder of the assets, assumed the liabilities, and paid Debtor $90,734.50 for his interest in the farm partnership.

In the years 2007-2010, Debtor received income from the farm partnership as follows: $197,297.00 in 2007, $191,759.00 in 2008, $167,283.00 in 2009 and $123,297.00 in 2010. (Debtor's Ex. P, H, I and J.) In 2008 and 2009, Debtor's gross farm income constituted more than 50% of the joint income of Debtor and his spouse as reported on their income tax returns. (Debtor's Ex. M and N.)

After the dissolution of the farm partnership, Debtor continued to farm in a smaller farming operation. Debtor initially leased approximately twenty-eight acres of the same land he previously farmed through the partnership. When that land sold in early 2011, Debtor began leasing twenty-six acres of land from his brother, Andrew. He also leased five additional acres of land. Debtor also helps Andrew out with his farm chores and sometimes trades labor with Andrew, or pays for his help, if he needs Andrew's machinery to work his fields. Debtor testifiedthat he's been a farmer all his life and would like to keep farming. He also stated he believed he needed to have farm ground to have a Chapter 12 case. Debtor filed his Chapter 12 bankruptcy petition on February 15, 2011.

Debtor has a $22,000.00 farm line of credit through St. Angsar State Bank (the "Bank") for crop inputs. In 2011—the year after the partnership ended—Debtor had gross farm income of $21,600.00 from raising corn. Debtor's fields in 2012 were in soybeans. Debtor estimates 2012 gross farm income will end up being $12,477.00.

In addition to running his own smaller farming operation, Debtor has been working two part-time jobs. In 2011, he had gross income of approximately $15,000.00 from Greg Krebsbach for doing farm labor and $5,143.00 from North Iowa Produce, Inc., a chicken processing plant. Debtor is unable to travel far for off-farm work because of a visual impairment.

Debtor's wife, Marybeth Hemann, works at Mayo Clinic in accounts payable. She pays the couple's monthly mortgage payment of $350.00 to the Bank from her wages. Mrs. Hemann and Debtor have agreed to borrow additional funds from the Bank, up to $20,000.00, to pay back taxes to the IRS and IDOR through Debtor's Chapter 12 Plan. This additional debt will be included in the mortgage. Themortgage payment will remain the same but the term will be extended to cover the additional debt.

The IRS and IDOR filed priority claims for taxes in Debtor's Chapter 12 case arising from the dissolution of the farm partnership. The IDOR filed a proof of claim for $27,596.00. The IRS filed a proof of claim in the amount of $97,457.39. After further review, the IRS reduced its claim to approximately $68,000.00. It has noted this could be reduced further if Debtor provides the IRS the amount of his cost basis in the farm partnership property. Both the IRS and IDOR treat the farm partnership dissolution transaction as a sale of a capital asset and assess tax on Debtor's capital gain.

Debtor's Chapter 12 Plan treats the income from the farm partnership sale as income from the sale of business property. In Exhibit K, a "traditional" tax return, Debtor reports owing 2010 federal taxes of $97,276.00, and 2010 Iowa taxes of $27,596.00. In Exhibit L, Debtor provides a 2010 "Pro Forma" return calculating his tax liability to illustrate how 11 U.S.C. § 1222(a)(2)(A)—the farm bankruptcy provision at issue here—applies. Debtor calculates a 2010 federal tax due of $10,766.00 and 2010 Iowa taxes owed of $3,864.00. Debtor's plan treats the remainder of the tax claims of the IRS and IDOR as unsecured claims under § 1222(a)(2)(A). Debtor admits the amounts of the "priority" tax claims may haveincreased to the extent that interest has accrued, but does not exceed $20,000.00—the maximum amount the Bank has agreed to lend to Debtor and his wife to pay these claims.

The parties agree that if Debtor is required to pay more than $20,000.00 in priority tax claims through his plan, the plan is not feasible. Debtor has insufficient income or other resources to pay the full amounts claimed by the IRS and IDOR as priority claims.

At the confirmation hearing, Debtor offered the expert testimony of Dr. Neil Harl regarding the treatment of small partnerships under the Internal Revenue Code. He stated that the farm partnership qualified for tax treatment under the "small partnership exception" of 26 U.S.C. § 6231(a)(1)(B). Dr. Harl testified the partnership was a pass-through entity, not a taxpayer and only filed informational tax forms. The farm partnership's income passed through to the individual partners, Debtor and his brother, Andrew Hemann. They reported the income on annual Schedule K-1s that the partners included with their individual tax returns. Dr. Harl asserted that, under the small partnership exception (26 U.S.C. § 6231(a)(1)(B)), the partnership entity is essentially ignored for tax purposes. He points to the language of the Internal Revenue Code—entitled "Exception for Small Partnerships"—that specifies: "The term partnership shall not include anypartnership having 10 or fewer partners . . . ." 26 U.S.C. § 6231(a)(1)(B). He essentially reasons that, like farm income from the farm partnership, farm partnership assets are treated for tax purposes as being owned by and ascribed to the individual because the partnership is ignored.

Debtor's recalculated 2010 tax return, according to Dr. Harl, properly treats Debtor's income as arising from the sale of assets owned by the individuals, using the small partnership exception. Dr. Harl asserts that properly computed under 26 U.S.C. § 6231(a)(1)(B) Debtor sold his personal interest in the assets of the farm partnership to Andrew Hemann, not his capital interest in the farm partnership. Dr. Harl reiterated several times that small partnerships are treated as if there was no partnership for federal tax purposes. Conceptually, the farm partnership entity was a mere conduit for income and assets that flow through to the individual partners.

The IRS and IDOR objected to Dr. Harl's testimony in its entirety as improper legal opinion. The Court took Dr. Harl's testimony subject to that objection.

The IRS and IDOR treat the farm partnership dissolution transaction as a transfer of Debtor's "partnership interest"—not a sale of "farm assets" as is required to get the benefit of § 1222(a)(2)(A). They assert that the sale of a "partnership interest" is a sale of a capital asset which receives capital gains tax treatment under conventional partnership rules. The Court allowed a revenue agent, Mary Snow, totestify under a pseudonym to protect her identity—over Debtor's objection. She computed Debtor's tax from the farm partnership sale under § 741 of the Internal Revenue Code, which specifies that any income from the sale of a partnership interest is treated as a capital gain. Ms. Snow stated she was not aware of 26 U.S.C.§ 6231(a)(1)(B)—the small partnership exception—before giving her deposition testimony in this case.

THE PARTIES' ARGUMENTS

The IRS first asserts Debtor is not eligible for Chapter 12. It argues that Debtor is not...