Input Costs – When Can a Deduction Be Claimed?

Overview

For farmers on the cash method of accounting, certain types of financing arrangements may create questions concerning when inputs are considered paid and, hence, qualify for a deduction.  Similarly, for livestock growers and feeders, letters of credit and advance payments for management services are common but can raise similar deductibility issues. 

For a cash basis farmer, inputs are deducted in the year that they are paid for.  In pre-payment situations, as long as the rules for pre-paying inputs are followed, there shouldn’t be an issue with achieving the up-front deduction.  See Rev. Rul. 79-229, 1979-2 C.B. 210.  But, what if the inputs are financed via a promissory note or a letter of credit?  Can a deduction be taken when the agreement is entered into?  What if the inputs are financed by a lender that is a subsidiary of the input supplier?  Relatedly, when can a deduction be claimed for financed improvements of depreciable property?  What about financing arrangements for feeding cattle?  What about buying a farm with a depreciable structure on it?

There are a lot of arrangements out there.  It can get messy in a hurry.  Today’ post takes a look at these issues.

Payment Via Promissory Note and/or Letter of Credit

The purchase of depreciable property on credit generally allows the buyer to receive an income tax basis for the purchase price cost of the property – including any liability assumed.  But, there can be situations where payment in accordance with a promissory note, even if secured by collateral, may not result in a deduction.  See Rev. Rul. 77-257, 1977-2 C.B. 174; Helvering v. Price, 309 U.S. 409 (1940).  The same could be true if payment is secured by a letter of credit. 

Livestock

In livestock feeding situations, letters of credit and advance payments for management services are common.  For example, in Chapman v. United States, 527 F. Supp. 1053 (D. Minn. 1981), a farmer entered into a purchase agreement for $30,000 worth of cattle feed.  The farmer paid one-half of the total amount in cash in 1973 and the remaining $15,000 was due and payable when each cattle lot was sold and was subtracted from cattle sale proceeds before any remaining balance was disbursed to the farmer.  To insure payment if the cattle sale proceeds didn’t cover the amount owed the seller of the feed, the farmer gave the seller a promissory note for $15,000 and a secured letter of credit for the same amount.  The farmer deducted the entire $30,000 in 1973 and recognized income of $15,000 in 1974 when the letter of credit expired.  The court held that the letter of credit was synonymous with a promissory note secured by collateral, and denied the $15,000 deduction in 1973 that was attributable to the note. 

In Bandes, et al. v. Comr., T.C. Memo. 1982-355, two taxpayers got into the cattle feeding business by contracting with a cattle company in Guymon, Oklahoma, to act as their agent and advisor for the purchase, feeding and sale of 1200 head of livestock.  The taxpayers agreed to share expenses and proceeds equally, and the contract with the cattle company appointed the cattle company as agent to select feedlots, negotiate and execute feeding contracts, and oversee the buying, managing and selling of the cattle.  The cattle company was also authorized to negotiate and contract for the delivery of the cattle by the end of 1972.  The cattle company would receive $8 per head for its management services and the taxpayers paid the fee on December 12, 1972 ($4,800 for each taxpayer).  The cattle company arranged for a line of credit to each taxpayer for 180 days from a bank set at a maximum of $210,000 per taxpayer at eight percent interest.  In the summer of 1973, the line of credit was renewed for another 180 days at 9 percent interest.  Security for the loan was the feed and livestock, and the taxpayers were not personally liable for any advances under the line of credit.  The advances from the bank paid a portion of the purchase price of the cattle and feedyard charges, and were repaid (except for interest which was paid in advance by the taxpayers) out of cattle sale proceeds.  In addition, advances were only made after each taxpayer had a net equity in the cattle of $90 per head.  Thus, on December 15, 1972, each taxpayer opened an account with the bank and deposited $54,000 ($90 x 600 head). 

On December 22, 1972, the cattle company purchased $96,000 worth of feed on each taxpayer’s behalf.  In early 1973, the cattle company bought 1,200 head of cattle for $411,352 that were then shipped to a feedyard.  During the remainder of 1973 the 1,153 surviving cattle were sold for $578,476.  Also in 1973, the unused feed was sold for $3,424. 

Both taxpayers were on the cash method and each of them deducted the $4,800 management fee on their respective 1972 returns along with a $48,000 deduction for cattle feed.  The IRS disallowed the deduction for the cattle feed in accordance with Rev. Rul. 79-229, but the court allowed the deduction on the basis that the taxpayers had a legitimate business purposes (locking in price) and that the payment was not a deposit and did not materially distort income. As for the management fee, the court allowed one-half of the fee to be deducted in 1972 and the other half in 1973, absent evidence as to the value of the services that the cattle company performed.

As for monthly maintenance fees paid under an agreement involving the purchase of cattle, the IRS has said that those fees are not deductible for the period before purchase of the cattle.  Rev. Rul. 84-35, 1984-1 C.B. 31.  Where an advance payment was made for management services for the current year and the succeeding year, the Tax Court has allocated the fee between the two years and allowed a deduction for the amount related to the current year.  Bandes v. Comr., T.C. Memo. 1982-355.

Financing Input Costs

In Rev. Rul. 77-257, 1977-2 C.B. 174, a limited partnership, was engaged in acquiring and holding land for investment and for farming.  The limited partnership was on the cash method of accounting.  A partnership was involved in management of farm properties.  The two entities were not related and had no common owners.  In the year in question, the limited partnership purchased farmland from the partnership and then entered into a management agreement with the partnership whereby the partnership was to provide development services on the farmland produced by the limited partnership.  The management expenses were billed monthly to a partnership account, and were paid by checks drawn on another partnership bank account. At the end of the development period, the limited partnership gave the partnership a note for the account receivable on the partnership account’s books.  The IRS cited Helvering v. Price, 309 U.S. 409 (1940) where the U.S. Supreme Court said that the issuance of a note by a cash method taxpayer, without any disbursement of cash or property with a cash value, does not give rise to a deduction.  But, the IRS also stated that “the actual payment of an expense with funds borrowed from a third party does give rise to a current deduction.” 

Vendor-financed inputs.  That last portion of Rev. Rul. 77-257, where the IRS said that actual payment of an expense with borrowed funds from a third party, opens the door to allow costs paid by vendor financing to be deductible.  Sometimes a farmer buys inputs that are financed by a lending subsidiary of the input supplier.  In many of these situations, the interest rate is set low to enhance sales.   But, the key is whether the lender that finances the input purchase is really independent from the vendor.  Rev. Rul. 77-257 says that when the funds are borrowed from a “third party,” a deduction for expenses incurred can be taken in the year the funds are loaned. But what if the lender is wholly-owned subsidiary of the vendor?  In that situation is the lender really a “third party” lender? 

Another issue can be created when the input financing by a wholly-owned subsidiary of the vendor occurs without the farmer writing out a check.  Does that give rise to deductibility?  What if the financing is provided by a different legal entity within the vendor’s business group?  It that really third-party financing if the financing company is wholly-owned by the vendor?  It gets a little blurry, doesn’t it?  All of this presents farmers with a challenge to identify the true nature of all parties that are involved in a transaction. 

Financed improvements to depreciable property.  Improvements to property which are financed by a promissory note or other obligation do not add to basis until the obligation is paid.  This is different than paying for the cost using borrowed funds, which doesn’t raise a concern.  Without a basis increase, there can be no depreciation deduction.  In Owen v. United States, 34 F. Supp. 2d 1071 (W.D. Tenn. 1999), the taxpayers financed improvements to office condominiums by promissory notes issued to an entity that the taxpayers owned and controlled. The taxpayers did not make any payment on the notes before selling the improved property. The taxpayers argued that the issuance of the notes for payment of the improvements increased their basis in the property, but the court distinguished the case (which involved a subsequent adjustment to basis) from those situations involving the taxpayer’s initial cost basis in property. The court noted that cash-basis taxpayers do not recognize income or expenses until cash is actually received or paid. Thus, the issuance of a promissory note as payment for benefits received was not a cash payment that allowed the taxpayers to take a current-year deduction.  It also did not increase the basis in the condominiums by the cost of the improvements.  The result was that no depreciation deductions would be allowed.

The Owen decision raises some interesting questions (which the court did not address), including how a taxpayer handles the sale of property purchased and financed by the taxpayer and subsequently sold while the taxpayer remained personally liable on the note.  For instance, assume that a farmer buys farmland with a building on it for cash.  The farmer financed improvements to the building, and then later sold the entire property while principal amounts were still outstanding on the note.  How does the farmer compute gain on the sale?  Does he count the amount financed as basis, or only add to basis any amount that has been paid on the note’s principal?  Or, does the farmer report more gain (because of no basis increase attributable to the amount financed) and then reduce the gain as payments are made on the note’s principal?  In the latter situation, the farmer would have to file an amended return for the year of sale each year that a principal payment is made.  If he doesn’t get the note paid off soon enough, he could end up with closed tax years that can’t be amended.  That would mean he would have gain recognition with no basis offset and the responsibility to still make principal payments.

Conclusion

You have heard it said many times that “cash is king.”  That’s true not only from a debt standpoint.  The tax issues associated with transactions can get complex fast when structured financing deals take place.