Friday, December 9, 2016
Cash method taxpayers generally can deduct their expenses for the tax year in which they are paid. However, for business and tax purposes, farmers often find it advantageous to prepay and deduct the cost of supplies. If structured properly, prepayment provides deductions in the year of the payment, favorable prices may be received, and planting and harvesting may be more efficient due to having adequate input supplies on hand. But, certain rules must be followed and the IRS can challenge transactions that aren’t within the guidelines.
In recent years, the IRS has indicated its opposition to the cash method of accounting for farmers. Up until the Tax Court decision in 2015, litigation involving a California farming operation using the cash method and prepaid expenses had been ongoing for several years. Another Tax Court case, decided yesterday, involved an IRS attempt to deny a deduction for prepaid expenses under the “tax benefit” rule. The IRS lost both cases.
Basic Rules on Pre-Paying and Deducting Input Costs
In accordance with Rev. Rul. 79-229, 1979-2 CB 210, to properly structure prepayments, the expenditure must be an actual payment rather than simply a deposit, and the prepurchased materials or supplies must be used within the next year to avoid a conflict with the IRS about whether the expense needs to be capitalized. Zaninovich v. Comm’r, 616 F.2d 429 (9th Cir. 1980), rev’g, 69 TC 605 (1978). In addition, farmers may not deduct prepaid farm supplies in excess of 50% of the otherwise deductible farming expenses (the “50% rule”). IRC §464(f).
2015 Tax Court Opinion
In Agro-Jal Farming Enterprises, Inc., et al. v. Comm’r, 145 T.C. No. 5 (2015), the plaintiff raised strawberries and vegetables. It used field-packing materials such as plastic clamshell containers and cardboard trays and cartons in its in-field packing process. It purchased these materials in bulk, in advance of the harvest. The supplies not used by yearend were reflected as expenses in its accrual basis financial statements in the year consumed, rather than when paid. The plaintiff reported its income for tax purposes on the cash basis, but prepared GAAP financial statements for financing purposes. The plaintiff also kept detailed records of the field packaging materials on hand at the end of the year, which it capitalized on its yearend financial statements.
The Tax Court was faced with the issue of whether the plaintiff could deduct the packaging materials in the year the materials were paid for or whether they could only deduct the amounts as the materials were used
The IRS conceded that cash method farmers may deduct farm supplies immediately upon purchase but argued that the farming syndicate rules limited an immediate deduction for expenses attributable to “feed, seed, fertilizer or other similar farm supplies.” It asserted that the plaintiff’s field packing materials were not “other similar farm supplies” for this purpose. The IRS cited the 50% rule of IRC §464(f) for the definition. However, if the field packing materials were farm supplies under this provision, the 50% limit would not be exceeded, and their cost would be fully deductible. In essence, the IRS argued that only feed, seed, fertilizer, or other similar farm supplies may be deducted immediately upon purchase but that all other supplies could only be deducted as consumed.
The plaintiff presented two counter-arguments. The first was that the field packing materials constituted “other similar farm supplies.” The second argument, based upon the farm syndicate rules, was that only those farmers who were within the definition of a farming syndicate were barred from using cash accounting. Because Agro-Jal did not fall under that definition, the plaintiff argued they could utilize the cash method for all farm supplies that were consumed within a year.
The Tax Court agreed with the plaintiff and held that the plaintiff’s expenses for field packing materials were fully deductible in the year of purchase. The court noted that the farm syndicate rules were aimed at abusive taxpayers (i.e., “farming syndicates” as that term is defined) and to certain especially abused expenses (i.e., feed, seed, fertilizer, or other similar farm supplies). Those situations were not present under the facts of the case.
The Tax Court also viewed feed, seed, and fertilizer as evoking a class of expenses associated with the growing of crops or the raising of livestock. The field packing materials were neither, the court reasoned, which would appear to place them outside the reach of the 50% test and the farm syndicate rule. Thus, the court agreed with the IRS on this point: because the named items in the statutory list (feed, seed, and fertilizer) are used directly in production activities, the field packaging materials were not “similar” to those items and were, therefore, outside the scope of IRC §464.
The court then proceeded to analyze the issue under the general rules for supplies (i.e., those supplies that are not “farm supplies”) contained in Treas. Reg. §1.162-3. That regulation was amended by TD 9636 (the tangible property regulations) effective for tax years beginning after 2013. However, under the version in effect for the tax years at issue, the court held that the supplies were not limited to deductibility in the year consumed because the taxpayer deducted them when paid. According to the court, Treas. Reg. §1.162-3 merely prevents a double deduction, once in the year paid and once in the year consumed, when it states: “provided that the costs of such materials and supplies have not been deducted … for any previous year.” Thus, the plaintiff was allowed to deduct the supplies when purchased, even though it accounted for the supplies not consumed by deferring the expense on its financial statements.
By determining the amount to report as a deferred expense on the balance sheet, the plaintiff had determined a physical inventory, meaning that the supplies were nonincidental. That is a distinction made by the tangible property regulations for tax years beginning after 2013. However, because the years at issue predated the effective date of the revisions made by the tangible property regulations, the Tax Court did not address the distinction between incidental and nonincidental materials and supplies. A different and more specific regulation, Treas. Reg. §1.162-12(a), applies to agriculture. This regulation provides that, “A farmer who operates a farm for profit is entitled to deduct from gross income as necessary expenses all amounts actually expended in the carrying on of the business of farming.” The court did not address Treas. Reg. §1.162-12(a) or mention it because it was not necessary. Because the IRS based its arguments solely on Treas. Reg. §1.162-3, the court kept its focus there. The court determined that Treas. Reg. §1.162-3 did not require capitalization because the amounts for the field packing materials were properly claimed in an earlier year.
2016 Tax Court Opinion
In Estate of Backemeyer v. Comr., 147 T.C. No. 17 (2016), the husband was a sole proprietor farmer who purchased crop inputs (herbicides, seeds, fertilizer and lime, fuel, etc.) worth over $200,000 in the fall of 2010 that he planned to use in connection with planting the spring 2011 crops. However, the husband died on March 13, 2011, before using any of the inputs. The inputs were listed in his estate’s inventory with their value pegged to their purchase price. Shortly before he died, he sold his 2010 crop in January of 2011 and that income was reported on line 3b of his 2011 Schedule F. His estate did not include any interest in any stored grain. The farm inputs passed to a family trust that named his surviving wife as the trustee.
The wife ran the farming operation after her husband’s death and took an in-kind distribution of the farm inputs from the trust which she used to grow corn and soybeans in 2011. She sold a portion of the crops grown in 2011 later that fall and reported those sale proceeds ($301,000) on line 3b of her 2011 Schedule F. She sold the balance of the 2011 crops in 2012, a year that she filed as a single taxpayer.
The couple filed a joint return for 2010 on which they claimed over $230,000 as pre-paid expenses. On the joint 2011 return, which included two Schedule Fs, the wife’s Schedule F claimed as expenses the exact same amount that had been claimed as pre-paid expenses on the husband’s 2010 Schedule F. The IRS rejected the deduction on the wife’s 2011 Schedule F, thereby increasing taxable income by $235,693 and resulting in a tax deficiency of $78,387. The IRS explained its reason for denying the deduction was because “the petitioners use the cash method for [their] farming activity, prepaid expenses that were paid in 2010 are deductible in 2010, and are not added to basis.” According to the IRS, the taxpayers were getting a double deduction which they were not entitled to, and if the court were to allow the deduction on the wife’s 2011 Schedule F, then that same amount should be included in the husband’s 2011 Schedule F. If that didn’t happen, the IRS claimed, a material distortion of income would result. The IRS also claimed that the surviving wife was not entitled to a step-up in basis under I.R.C. §1014 in the inherited farm inputs. The IRS also tacked on an accuracy-related penalty under I.R.C. §6662(a) of $15,864.
In its reply brief, the IRS jettisoned all of those arguments and claimed that the tax benefit rule controlled the outcome of the case. Thus, the surviving spouse properly deducted the inputs on her 2011 return because she had received the inputs with a stepped-up basis and proceeded to use them in her farming business. But, IRS claimed, the tax benefit rule required the inclusion in the husband’s 2011 return of the amount of the prepaid input expense that had previously been deducted in 2010. The IRS claimed that Bliss Dairy, Inc. v. Comr., 460 U.S. 370 (1983) required that outcome. In that case, a cash method corporate dairy deducted the purchase cost of cattle feed. Early in the next year, the corporation liquidated while there was a significant amount of feed remaining on hand. The corporation distributed its assets to its shareholders in a nontaxable transaction. The shareholders continued to operate the dairy and deducted their basis in the feed as an expense of doing business. The U.S. Supreme Court said that the tax benefit rule applied because the liquidation of the corporation changed the cattle feed to being used in a non-business use which was now inconsistent with the earlier deduction. The IRS said the facts of the current case were the same and should produce the same result. The IRS claimed that because the husband died before using the inputs in his farming business, the inputs were converted to a non-business use at the time they were transferred to the trust. Then, upon distribution to the wife for use in her farming business, the inputs were converted back to business use which entitled her to deduct their cost, but also required the husband’s return to recognize income because he converted the inputs from one use to another by dying unexpectedly at the wrong time.
The Tax Court didn’t buy the IRS argument. In Frederick v. Comr., 101 T.C. 35 (1993), the Tax Court laid out a four-factor test for application of the tax benefit rule: (1) a deduction was taken in the prior year; (2) the deduction resulted in a tax benefit; (3) an event occurred in the current year that is inconsistent with the premises on which the deduction was originally based; and (4) a nonrecognition provision of the Code does not prevent inclusion in gross income. While the first two factors were satisfied, the Tax Court determined that factors (3) and (4) were not. As to factor (3), the court noted that neither the husband’s death nor the distribution of the inputs to his wife for use in her farming business were inconsistent with the deduction on his 2010 return. The Tax Court noted that had the wife inherited the inputs in 2010 and used them in 2010, the initial deduction would not have been recaptured for income tax purposes because of the estate tax. They were subject to the estate tax on their purchase price, which was the same basis for the income tax deduction. Thus, application of the tax benefit rule would result in double taxation of the value of the inputs.
Factor (4) had also not been satisfied. Upon the husband’s death, the basis step-up rule applied. Also, the gross income of the recipient of an asset does not include the value of the inherited assets. Upon disposition by the heir, the heir has taxable gain only to the extent the proceeds exceed the stepped-up basis. Also, upon death, depreciation recapture is not triggered under either I.R.C. §1245 or I.R.C. §1250. Those rules are a partial codification of the tax benefit rule and don’t apply at death.
Thus, the tax benefit rule did not apply and require the inclusion in the husband’s 2011 Schedule F of the amount that had been deducted for the pre-paid inputs that were claimed on the 2010 Schedule F. In addition, the court also removed the accuracy-related penalty.
Farmers are specifically allowed to deduct amounts actually expended that are attributable to items used in conducting their farming business. This general principle is only limited if other specific Code provisions provide otherwise (e.g., IRC §263A for the uniform capitalization rules, IRC §464 for the 50% rule, IRC §175 for soil and water conservation expenditures, etc.). In addition, Treas. Reg. §1.162-12(a) was not impacted in any manner by the tangible property regulations, and it remains the authority for farmers to deduct “all amounts actually expended in carrying on the business of farming.” In addition, the tax benefit rule is inapplicable where crop inputs are deducted in an earlier year and then again in a later year by a surviving spouse who inherits the inputs as the result of a spouse’s unexpected death and uses them in the surviving spouse’s farming business.