Monday, December 19, 2016
Before the Tax Reform Act of 1986, taxpayers had the option of either capitalizing or deducting expenses incurred during a business asset's pre-productive period. However, for taxable years beginning after 1986, taxpayers must capitalize the direct costs of production and the “proper share” of indirect costs which are assignable to the production of property that the taxpayer uses in their trade or business. I.R.C. §263A. This is known as the uniform capitalization rule, and it prevents the current deduction of these costs during the pre-productive period.
Plants and certain animals have pre-productive periods, so what’s the impact of the rule on farmers and ranchers? In addition, what are “indirect costs of production? Do they include interest and property taxes? A recent Tax Court decision sheds some light on these questions.
Does the Rule Apply To Animals?
The 1986 rule change applied to both animals and plants. As applied to animals, if the pre-productive period was more than two years, a taxpayer could not deduct expenses associated with the pre-productive period of replacement heifers for a cow/calf or dairy herd, for example. Instead, the taxpayer had to keep track of costs and capitalize them. This became known as the “heifer tax.”
In 1988, the Congress repealed the capitalization rule as to animals produced by the taxpayer in a farming business for costs incurred after 1988. The repeal provisions refer to animals and not livestock. So this rule as to animals has been eliminated effective for costs incurred after 1988, but the trade-off for repeal was that, starting in 1989, all farm property of a taxpayer engaged in a farming business slowed to a 150 percent declining balance depreciation method as a maximum.
Application to Plants
The uniform capitalization rules are still in effect for plants that are used in a farming business. Consequently, taxpayers who have a long-term crop with more than a two-year pre-productive period are not permitted to deduct the costs associated with that crop during the pre-productive period. There are some nuances to the application of the rule, but it primarily impacts taxpayers that are in the nursery business and almost all tree, vine or bush crops that require at least two years to reach production. For example, the IRS has said that a nursery could deduct the cost of purchasing “bare root” trees as an ordinary and necessary business expense where the trees were all very young Tech. Adv. Memo. 9818006 (Jan. 6, 1998). Many trees did not survive and all required years of development and cultivation to ensure future marketability. In essence, the trees qualified as “seeds and young plants” under Treas. Reg. § 1.162-12. Where some grow-out is contemplated, nursery operators do not need to capitalize associated costs if the pre-productive period is two years or less. IRS Ann. 97-120, I.R.B. 1997-50, 61. Also, IRS has stated that costs incurred between the harvest of a grape crop and the end of the pre-productive period must be capitalized unless they are “field costs” (i.e., irrigation, fertilization, spraying and pruning) that provide no benefit to the already severed crop. ILM 200713032 (Nov. 20, 2006).
The pre-productive period begins when the seed is planted or the plant is first acquired by the taxpayer, and it ends when the plant is ready to be produced in marketable quantities or when the plant can reasonably be expected to be sold or otherwise disposed of – basically from the time of planting to the time of first harvest. The pre-productive period, however, is determined not in light of the taxpayer's personal experience but in light of the weighted average pre-productive period determined on a nationwide basis. In other words, a taxpayer can’t use its own experience to determine whether a plant or crop has a pre-productive period of two years or less. See, e.g., Pelaez and Sons, Inc. v. Com’r., 2000-1 U.S. Tax Cas. (CCH) ¶50,395 (11th Cir. 2001), aff’g, 114 T.C. No. 28 (2000). In addition, the uniform capitalization rule applies even if the taxpayer acquires land with a growing crop in the midst of the crop’s pre-productive period and there is less than two year left until the crop becomes marketable.
The IRS has provided a list of plants grown in commercial quantities in the United States that have a nationwide weighted average pre-productive period in excess of two years. IRS Notice 2000-45, I.R.B. 2000-36. Included on the list are almonds, apples, apricots, avocados, blueberries, cherries, chestnuts, coffee beans, currants, dates, figs, grapefruit, grapes, guavas, kiwifruit, kumquats, lemons, limes, macadamia nuts, mangoes, nectarines, olives, oranges, peaches, pears, pecans, persimmons, pistachio nuts, plums, pomegranates, prunes, tangelos, tangerines, tangors and walnuts. Blackberries, raspberries and papayas used to be on the list, but the IRS removed them in 2013. Rev. Proc. 2013-20, Sec. 2.06.
Do Capitalized Costs Include Interest and Property Taxes?
Under the uniform capitalization rules, certain costs of production must be capitalized. Do those costs include interest associated with the acquisition of land on which a crop with a more than two-year pre-productive period is grown and property taxes paid on that land? I.R.C. §263(A)(f)(1) specifies that “interest is capitalized when (1) the interest is paid during the production period and (2) the interest is allocable to real property that the taxpayer produced and that has a long useful life, an estimated production period exceeding two years, or an estimated production period exceeding one year and a cost exceeding $1 million. The corresponding regulation states that “…capitalization of interest under the avoided cost method described in Treas. Reg. §1.263A-9 is required with respect to the production of designated property…”. The rules also require the capitalization of real property taxes incurred during the production period.
In Wasco Real Properties I, LLC, et al. v. Comr., T.C. Memo. 2016-224, the taxpayer was three partnerships that bought land that they planned to use for growing almonds. They financed the purchase by borrowing money and paying interest on the debt. They deducted the interest and property taxes on their return. The IRS objected on the basis that the interest and real property taxes were indirect costs of the “production of real property (i.e., the almond trees that were growing).
In determining whether the uniform capitalization rules applied to interest and real property taxes, the court noted that I.R.C. §263A(b)(1), (c)(1) applies to real property produced by the taxpayer for the taxpayer’s use in a trade or business or in an activity conducted for profit, and that the definition of “real property” includes “land” and “unsevered natural products of land.” “Unsevered natural products of land” generally include “[g]rowing crops and plants where the pre-productive period of the crop or plant exceeds two years.” While almond trees are on the IRS list as having a pre-productive period of more than two years, the taxpayer claimed they could currently deduct the interest and property taxes because those costs related to the land and not the almond trees. In other words, the taxpayer claimed it was not in the business of producing land, but almonds. The court didn’t buy the argument. While the court agreed that the taxpayer was in the business of growing almonds, the trees grew on the land. As such, land itself need not be produced because the almond trees are intertwined with the land and cannot grow without it. Thus, the placing in service of the almond trees required that the land be placed in service, and the interest and tax cost of the land was a necessary and indispensable part of the growing of the almond trees. The unit of property was the land and the almond trees. So the property taxes and interest associated with the portion of the land benefiting the almond trees had to be capitalized.
Accounting Method Issues
The Tax Court, in Wasco, said that the taxpayer had to change its method of accounting for the interest and property tax cost, and pick up the amounts deducted in prior years that should have been capitalized. That will trigger an I.R.C. §481(a) adjustment. So, a Form 3115 will be required to change the method of accounting. While an accounting method cannot be changed more frequently than once every five years, Form 3115 does not cover blanket accounting method changes. It applies to a particular trade or business activity. That means that if, for example, a Form 3115 had been filed (even if unnecessarily) within the immediately preceding five years for purposes of the recently implemented repair/capitalization regulations, another Form 3115 can be filed for purposes of the uniform capitalization rules.
Avoiding the Rule
An election can be made to avoid capitalization of pre-productive costs, but if the election is made, all farm assets must be depreciated using the alternative depreciation system. I.R.C. §263A(d)(3) and (e)(2). That requires straight-line depreciation over the class life of the property for all farm assets of the taxpayer that are used in the farming business. There is, however, a limitation on the use of the election that applies to citrus and almond growers. I.R.C. §263A(d)(3)(C). In addition, the election (made via Form 3115) must be made for the first year in which costs subject to the capitalization rules apply. That means that the election might be a good move for taxpayers just starting out in farming who don’t have a lot of income to offset with farm deductions or those that don’t have a great deal of depreciable assets. Conversely, agricultural producers that don’t raise many crops with a more than two-year pre-productive period probably don’t want to make the election and thereby preserve their ability to use MACRS depreciation on farm assets (as well as first-year “bonus” depreciation).
Another way to avoid the impact of the uniform capitalization rules is to make an I.R.C. §179 election. Treas. Reg. §1.263A-4(d)(4)(ii). Also, starting in 2016, a taxpayer can elect bonus depreciation for fruit/nut plants at the time of planting or grafting rather than waiting until the plants become productive. Rev. Proc. 2015-48, 2015-40 IRB 469.
The uniform capitalization rules have an important impact of growers of many trees and plants. The Tax Court’s Wasco opinion illustrates that pre-productive costs include a wide array of costs incurred during the pre-productive period.