Monday, February 13, 2017
IRS has a long history of challenging taxpayers that it believes are distorting income reporting by use of the cash method of accounting. As examples of the continued IRS attack on farmers using the cash method of accounting, in 2016, the IRS tried to deny a farmer’s surviving spouse a deduction for the cost of inputs she used to plant the crop that he had purchased before death, but died before he could use them to plant the spring crop. Estate of Backemeyer v Comr., 147 T.C. No. 17 (2016). While the farmer had deducted the costs of the inputs as pre-paid expenses in the year before he died, the IRS claimed she couldn’t deduct the same amount the following year on her return even though the value of the inputs were included in his estate under I.R.C. §1014. The IRS position revealed a complete misunderstanding of associated tax rules and the Tax Court let the IRS know it in ruling for the estate.
In 2015, the IRS tried to deny a deduction for a California farming corporation that deducted the cost of fieldpacking materials until the year the materials were actually consumed. The IRS lost the case based on its own regulation. Agro-Jal Farming Enterprises, Inc., et al. v. Comr., 145 T.C. 145 (2015). A year earlier, a federal appeals court, in a case involving a Texas cattle and horse breeding limited partnership sternly disagreed with the IRS attack on that operation’s use of cash accounting via the “farming syndicate rule.” Burnett Ranches, Limited v. United States, 753 F.3d 143 (5th Cir. 2014). Despite the rebuke, the IRS has now issued a non-acquiescence to the court’s decision, signaling that their attack on the cash method will continue. AOD 2017-7; 2017-7 IRB 868.
In both the 2014 Texas case and the 2015 California case, the IRS trotted-out the “farming syndicate” rule in an attempt to bar the deductions. Because the IRS has now issued a non-acquiescence to the 2014 Fifth Circuit decision which signals its intent to continue examining the issue outside the Fifth Circuit, today’s blogpost is a reminder to practitioners of what the IRS is looking for and why the Courts have rejected their theories.
The Farming Syndicate Rule
In the farm and ranch sector, that alleged distortion often arises in the context of pre-payment for inputs such as fertilizer, seed, feed or chemicals. Various tests and rules have been adopted over the years to deal with material distortions of income when pre-purchases are involved. See, e.g., Rev. Rul. 79-229, 1979-2 C.B. 210. One of those rules, which is designed to place a limitation on deductions for farming operations, was developed in the 1970s and is known as the Farming Syndicate Rule. I.R.C. §461(j). The Congress enacted the rule in 1976, and it eliminates “farming syndicates” from taking deductions for feed, seed, fertilizer and other farm supplies before the year in which the supplies are actually used or consumed. The rule establishes two tests for determining whether a farming syndicate is present. A farming syndicate is (1) a partnership or other enterprise (except a regularly taxed corporation) engaged in farming if the ownership interests in the firm have been offered for sale in any offering required to be registered with any federal or state securities agency (I.R.C. §461(j)(1)(A)) or (2) a partnership or other enterprise (other than a C corporation) engaged in farming if more than 35 percent of the losses during any period are allocable to limited partners or “limited entrepreneurs.” I.R.C. §461(j)(1)(B).
IRS Position. The “farming syndicate” rule does not impact many farming and/or ranching operations, but it does catch some of the extremely large operations and a few individuals who are inactive investors in farming operations. That’s because there is an exception to the rule for holdings attributable to “active management.” If an “individual” has actively participated (for a period of not less than 5 years) in the management of the farming activity, any interest in a partnership or other enterprise that is attributable to that active participation is deemed to not be held by a limited partner or a limited entrepreneur. I.R.C. §461(j)(2)(A). That means that the interest doesn’t count toward the 35 percent test. But, IRS has taken a strict interpretation of the statute. In the IRS view, the exception for active management only applies to an “individual.” Indeed, the statute does state, “in the case of any individual [emphasis added] who has actively participated…”. I.R.C. §461(j)(2)(A). Thus, in C.C.A. 200840042 (Jun. 16, 2008), the Chief Counsel’s office determined that a partnership interest held by an S corporation with only one shareholder was to be treated as held by a limited partner for purposes of the farming syndicate rule. The partnership raised and bred livestock, and its members were two trusts along with the S corporation. The S corporation was owned by a trustee who was also a beneficiary of the trusts. One of the trusts was the general partnership of the partnership. The partnership reported income on the cash method, but IRS took the position that the partnership interest that the S corporation held had to be treated as a limited partner interest because it wasn’t held by an “individual.” This was the result, according to the IRS, even though the S corporation’s sole shareholder was an individual. Thus, for purposes of the farming syndicate rule, the interest held by the S corporation was treated as an interest that was held by a limited partner.
Burnett Ranches involved a Texas cattle and horse breeding limited partnership that was 85 percent owned by an S corporation as a limited partner. As such, the limited partnership met the definition of a farming syndicate. However, the court held that the ranch qualified for the active participation exception to the farming syndicate rule even though the majority owner actively participated in managing the cattle operation through the owner’s wholly-owned S corporation. The court noted that the west Texas operation had been family-run for many generations dating back into the 1800s, with the current majority owner family member simply owning her interest via an S corporation. There was no question that that majority owner managed the operation and would satisfy the active management test in her own right. The IRS acknowledged as much. But, IRS said the farming syndicate rule was triggered and cash accounting was not available because the ownership interest was held in an S corporation rather than directly by the majority shareholder as an individual. Consequently, IRS said that the partnership could not use cash accounting for the years in issue – 2005-2007. The limited partnership paid the alleged deficiencies (which amounted to several million dollars) and sued for a refund in federal district court. The sole basis for the IRS denial of the cash method under the farming syndicate rule and the required switch to the accrual method was the fact that the S corporation owned the partnership interest, even though it was an S corporation that was 100 percent owned by the person that performed the entire management function of the business. The district court ruled for the limited partnership.
The IRS appealed, continuing to maintain that the majority owner’s interest in the limited partnership via her S corporation barred the active management exception from applying. The court disagreed, largely on policy grounds. The court noted that the Congressional intent behind the active management exception of I.R.C. §464(c)(2)(A) was to target high-income, non-farm investors, not the type of taxpayer that the majority owner represented. The court stated, “Ms. Marion’s business and ownership history with these ranches and their operations is the very antithesis of the “farming syndicate” tax shelters that §464 was enacted to thwart….”. Indeed, the owner of the S corporation was the current descendant in a long line of descendants of the founder of the ranching operation dating to the mid-1800s. The court went on to state, “[We] doubt that our interpretation of §464 will stymie the I.R.S., an agency tasked with uncovering abusive tax-avoidance schemes of myriad forms, not just those in the nature of a farming syndicate…. We deem it beyond peradventure that her limited partnership interest in Burnett Ranches is excepted from §464’s primary thrust of requiring farming syndicates to employ the accrual basis of accounting.”
The court also noted that the statutory term “interest” was not synonymous with legal title or direct ownership, but rather was tied to involvement with or participation in the underlying business. Thus, the court determined that there was no basis for distinguishing between “the partnership interest of a rancher who has structured his business as a sole proprietorship and a rancher who has structured his business as [a subchapter S] corporation.” The term “individual” was used in the statute to refer to the provision of active management rather than in reference to having an interest in the activity at issue.
The court’s opinion provides needed guidance on the narrow interpretation of the farming syndicate rule by the IRS. The opinion is binding authority inside the Fifth Circuit - Louisiana, Mississippi and Texas. But, with AOD 2017-7; 2017-7 IRB 868, the IRS has signaled that it will pick more battles on the same issue elsewhere. That seems a bit ridiculous on this issue. The IRS is spending its budget to pursue collection of tax dollars based upon its technical reading of required “active participation,” ignoring the 85 percent effective ownership of the person who, as was stipulated, actively participated.
It is no wonder that Congress has reduced the IRS budget over the years trying to send the message to the IRS to go after the real abuses, and don’t bother taxpayers that are trying to comply with the tax laws. This family involved in Burnett Ranches actively managed the ranches for over 150 years, long before the income tax was a problem (and in fact, before the area became part of the United States!). The IRS should leave honest taxpayers alone, and go after syndicates that are truly abusive.