Friday, March 17, 2017
While purchased livestock that is held primarily for sale must be included in inventory (along with all items that are held for sale or for use as feed, seed, etc., that remain unsold at the end of the year), livestock that is acquired (e.g., purchased or raised) for draft, breeding or dairy purposes may be depreciated by a farmer using either the cash or accrual method of accounting, unless the livestock is included in inventory. Treas. Reg. §1.167(a)-6(b). Cash basis farmers and ranchers are allowed to currently deduct all costs of raising livestock, thus only purchased livestock are required to be capitalized and held in inventory or depreciated.
The decision to depreciate livestock (including fur-bearing livestock) or include them in inventory can be an important one for many farmers and ranchers. That’s the focus of today’s blog post.
Section 1231 Assets
I.R.C. §1231 refers to depreciable business property that has been held for more than one year, and includes buildings and equipment, timber, natural resources, unharvested crops, and livestock among other types of business assets. One benefit of I.R.C. §1231 is that gains and losses on I.R.C. §1231 property are netted against each other in the same manner as capital gains and losses except that a net I.R.C. §1231 gain is capital in nature (e.g., taxed at a preferential rate), but a net I.R.C. §1231 loss is treated as an ordinary loss. A special provision in I.R.C. §1231(b)(3) requires that cattle and horses held for draft, breeding , dairy or sporting purposes must be held for at least 24 months to qualify for I.R.C. §1231 status. Other livestock is only required to be held for at least 12 months. It does not include, for example, inventory and property held for sale in the ordinary course of business.
I.R.C. §1231 tax treatment is not available if the taxpayer includes livestock in inventory. However, a farmer might have animals listed in the closing inventory in a year that are then transferred to the depreciation schedule in the next year upon the animals reaching maturity and becoming productive. In that event, the inventory value of the animals in the first year’s closing inventory should be subtracted from the beginning inventory for the subsequent year.
Even some livestock that does not come within the category of I.R.C. §1231 is depreciable. For example, poultry held for more than one year for breeding or egg-laying purposes may be depreciated if not held primarily for resale. Treas. Regs. §§1.167(a)-3; 1.167(a)-6(b). But, livestock held for sporting purposes is not made specifically depreciable. See Treas. Reg. §1.167(a)-6(b). However, sporting assets may be depreciated as business assets.
Sheep and furbearing animals have been held to be I.R.C. §1231 assets. That at least implies that the animals would be depreciable. See Treas. Reg. §§1231-1; 1.1231-2(a)(3). One case, however, has disallowed depreciation deductions for sheep held for breeding, wool and resale purposes. Belknap v. United States, 55 F. Supp. 90 (W.D. Ky. 1944).
Depreciate or Include in Inventory – That is the Question
The key question for a farmer/rancher is whether livestock should be depreciated or included in inventory. The depreciation of livestock is beneficial to the producer for many reasons. First, depreciation is an ordinary deduction and thus reduces the farmer’s net income and self-employment income. Second, although the depreciation taken on the livestock must be recaptured under I.R.C. §1245, this recapture is not subject to self-employment tax for Schedule F and farmers operating in the partnership form. Third, the amount of gain in excess of original cost, if held for the applicable period, is taxed at favorable capital gains rates under I.R.C. §1231.
Farmer Jones purchases a cow for breeding purposes and pays $2,000 on January 1, 20X1. Over the next three years, Farmer Jones takes $1,160 of depreciation on the cow, thus reducing his farm income and self-employment income by this amount. He then sells it for $3,000 on January 1, 20X4. At that time, Farmer Jones is required to recapture the $1,160 of depreciation originally taken on the cow at ordinary income tax rates (however, it is not subject to self-employment tax) and the $1,000 gain in excess of original cost of $2,000 is subject to long-term capital gains rates since he held the cow for more than two years.
So, is this a better tax result than capitalizing the cow and holding it in inventory? The answer turns on whether a current deduction for depreciation will outweigh subsequent capital gain treatment upon sale. Also, that eventual capital gain treatment will be limited by depreciation recapture which means that ordinary income rates will apply to the portion of the gain on sale attributable to the amount of depreciation previously claimed.
What About Accural Basis Taxpayers?
In general, if an accrual basis farm taxpayer wants to achieve a lower tax rate on future gains from the qualified sale of breeding, draft, dairy or sporting livestock, livestock should generally be inventoried at the lowest possible value. If that is done, care should be taken in selecting the inventory method that is utilized. Because any particular animal’s inventory value pegs its basis for the computation of gain or loss on sale, the inventory method impacts the ordinary gain on sale. Thus, any method that assigns a relatively low value to an animal will result in a relatively greater ordinary gain upon the animal’s sale. Remember, any livestock held for sale that is not breeding, draft, dairy or sporting livestock is subject to ordinary income tax rates, regardless of the period of time held. It is only livestock held for breeding, draft, dairy or sporting purposes that qualify for long-term capital gain rates under I.R.C §1231.
Here are the available methods, and whichever one is utilized must conform to generally accepted accounting principles and must clearly reflect income.
- Cost method. This method simply values inventory at its cost, including all direct and indirect costs.
- Lower-of-cost-or market method. This method compares the market value of each animal on hand at the inventory date with its cost, and uses the lower of the two values as the inventory value for that animal.
- Farm-price method. This inventory method values inventories at market price less the direct cost of disposition. If this method is utilized, it generally must be applied to all property that the taxpayer produces in the taxpayer’s trade or business of farming – except for any livestock that are accounted for by election under the unit- livestock-price method of accounting.
- Unit-livestock-price method. Under this method of inventorying livestock, the livestock are classified into groups based on age and kind and then the livestock in each group (class) is valued by using a standard unit price for each animal in that class. Essentially, the taxpayer divides the livestock into classifications that are reasonable based on age and kind, with the unit prices for each class accounting for the normal costs of producing and raising those animals. If purchased livestock are not mature, the cost of the livestock must be increased at the end of each year in accordance with the established unit prices, except for animals acquired during the last six months of the year. This can result in a situation where the taxpayer receives a current deduction attributable to the costs of raising the livestock without any additional unit increase in the animal’s closing inventory.
When an animal is included in inventory at its unit price at maturity, its inventory value cannot be written down later to reflect a decline in its value because of, for example, a loss in value due to aging irrespective of whether the animal has not yet reached marketable age.
For taxpayers that anticipate generating significant income from the sale of draft, dairy or breeding livestock and who inventory livestock, an inventory method (such as the lower of cost or market method and the unit-livestock-price method) that maximizes capital gain on sale rather than income in the years preceding sale will likely be beneficial. However, consideration should be given to the principle that inventorying livestock will usually cause a reduction in current deductions against ordinary income. On the other hand, for livestock that are depreciated, depreciation deductions previously taken are recaptured as ordinary income upon sale of the livestock, but this income is not subject to self-employment tax and the amount of gain in excess of original cost is subject to favorable long-term capital gains treatment.