Thursday, December 13, 2018
In general, a farmer or rancher that uses the cash method of accounting gets to deduct business-related expenses in the year that they are paid. But, is that always the case? What about livestock that is purchased for resale, or growing crops associated with the purchase of a farm? Are there other special situations in the farm or ranch setting? Does the Tax Cuts and Jobs Act (TCJA) have any impact?
The cash method of accounting and special situations for farmers and ranchers – it’s the topic of today’s blog post.
As stated above, the general rule for taxpayers on the cash method of accounting is that a deduction can be claimed for expenses when those expenses are paid. However, for farmers and ranchers that utilize the cash method of accounting, a deduction can be taken for the cost of livestock and other items that are purchased for resale only when the items are sold. Treas. Regs. §1.61-4(a). For example, in Alexander v. Comr., 22 T.C. 234 (1954), acq., 1954-2 C.B. 3, the petitioner was a cattle feeder that purchased calves and yearlings. He fed them for approximately nine to 18 months and then sold them as beef cattle. He was on the cash method of accounting and deducted the cost of the cattle in the year of purchase as an operating expense rather than deferring the deduction until the year he sold the cattle. The IRS disagreed with that approach and the Tax Court upheld the IRS position and the underlying Treasury Regulation. The cattle feeder’s gain on later sale was to be reduced by the cost of purchase.
Other Ag Products
The rule applied in the Alexander case is widely recognized as the “feeder calf” rule whereby the cost of feeder calves is not deductible until the calves are sold. However, the rule has much broader application beyond the feeder calf scenario. For instance, in Dodds v. Comr., T.C. Memo. 1986-174, the Tax Court held that the rule required the taxpayers to deduct the cost of their Valencia orange tree grove attributable to the growing orange crop when the crop was sold. The Tax Court noted that Treas. Reg. §1.61-4 applies to livestock and produce.
The same tax treatment applies to grain and other items that are purchased for resale. For example, if a farmer pledges grain to the Commodity Credit Corporation (CCC) as collateral for a loan and the grain goes out of condition and is sold, if that grain is replaced with the same quantity of grain (that meets CCC standards for quality) that will be sold, the purchased grain acquires an income tax basis equal to the purchase price. The purchase price amount would then offset (either partially or fully) the amount realized on later sale of the grain. The same rationale applies when a farmer buys a commodity certificate and then uses the certificate to acquire grain for later resale, the purchase price of the grain would establish the farmer’s tax basis in the grain. That tax basis would then be used to offset gain (or create a loss) on later sale.
Inventory Method Application
The IRS also takes the position that a “last-in-first-out” (LIFO) method to account for inventory costs may not be used to determine the cost to be deducted in the year of sale. In Rev. Rul. 88-60, 1988-2 C.B. 30, the taxpayer was engaged in the business of acquiring livestock for the purpose of resale. The taxpayer, a corporation, utilized the cash method and computed the profits from the sale of the livestock by determining the cost of the livestock sold as if the latest cattle acquired were the first sold. The cost basis of the remaining unsold cattle at the end of the year reflected the cost of the earliest cattle that the taxpayer had acquired. The IRS took the position that this method did not reflect the actual cost of the livestock sold, and was not permitted by Treas. Reg. §1.61-4 because it reflected the cost of the latest purchases of calves and yearlings. That wasn’t, the IRS determined, consistent with the cash method of accounting. Instead, the cost was to be subtracted from the particular item sold and cannot be deducted from other similar items sold. Allowing the use of the LIFO method would allow the taxpayer to deduct part of the cost of the feeder cattle in the year in the year of purchase rather than deferring the deduction until the year of sale. In other words, “cost” in Treas. Reg. §1.61-4 meant the actual cost of the livestock rather than the base year cost as determined under LIFO. See also, Priv. Ltr. Rul. 8406003 (Oct. 18, 1983); Peterson v. Vinal, 225 F. Supp. 478 (D. Neb. 1964).
Farmland With Growing Crop
When a farm is purchased that has a growing crop (or crops) on it, the IRS position is that the portion of the purchase price allocated to the growing crop does not produce a current income tax deduction. Instead, the amount allocated to the growing crop is to be capitalized and taken into account when determining net profit or loss in the year that the crop is sold. Rev. Rul. 85-82, 1985-1 C.B. 57. See also Priv. Ltr. Rul. 8350002 (Aug. 8, 1983); GCM 39096 (Dec. 21, 1983). It is not deductible on purchase of the farm as a purchase of “feed” unless the taxpayer intends to feed the crop to livestock. In that case, current deduction would seem to be permissible as to a reasonable amount of the acquired crop that is necessary to feed the taxpayer’s livestock.
What About Poultry?
A current deduction is allowed for the cost of purchasing baby chick and egg-laying hens by a farmer that uses the cash method of accounting as long as the method is consistently followed and clearly reflects income. The same is true if they are purchased for the purpose of raising and later resale. In Rev. Rul. 60-191, 1960-1 C.B. 78, the IRS took this position because it determined that the cost of the chicks was nominal compared to the cost of raising them, and because cost identification would be difficult. See also Priv. Ltr. Rul. 8528027 (Apr. 15, 1985). Whether that same rationale applies to other types of poultry, such as ostriches and emus, is an open question.
Impact of the TCJA
Section 13102 of the TCJA makes several amendments to the accounting rules for “small” businesses. In a significant change from prior law, for tax years beginning after 2017, a farming business (including a farm C corporation or a farming partnership with a C corporation partner) can qualify for the cash method of accounting if average gross receipts over the prior three years immediately before the tax year at issue do not exceed $25 million ($26 million for 2019). I.R.C. §448. The TCJA also contains a provision that exempts taxpayers that meet the gross receipts test from the requirement to account for inventories so as to clearly reflect income. However, the taxpayer’s method of accounting for inventory must either treat the inventory as non-incidental materials and supplies, or conform to the taxpayer’s method of accounting reflected in an applicable financial statement (AFS) for the tax year. If the taxpayer doesn’t have an AFS, the taxpayer’s method of accounting must conform to the taxpayer’s books and records “prepared in accordance with the taxpayer’s accounting procedures.” I.R.C. §471(c).
So what does this mean for farmers? For starters, if inventory is accounted for as incidental materials and supplies, inventory accounting methods don’t apply. As noted above, the IRS will not allow the use of LIFO, but FIFO or average cost method could be used. See, Rev. Proc. 2002-28, 2002-1 C.B. 815. But, does this mean that a farmer can claim a deduction in the year of purchase for livestock and other items that will be resold in a later year? That may be the case if the items fit within the definition of incidental supplies, and the farmer’s books and records consistently expense the items, and the farmer does not have an AFS (very few will).
Under the tangible property regulations, the IRS provided a de minimis safe harbor limit for those without an AFS. See Treas. Reg. §1.263(a)-1(f)(1)(ii)(D). In Notice 2015-82,2015-50 IRB, the IRS set that safe harbor at $2,500 (effective beginning with tax year 2016) for purposes of administrative convenience to allow a taxpayer to deduct amounts within the safe harbor limit that are expended for the acquisition or production of new property or for the improvement of existing property which would otherwise have to be capitalized under I.R.C. §263(a). To use the safe harbor, the item must be substantiated by an invoice. The $2,500 safe harbor should apply for feeder pigs. Cattle, however, may not as easily fit within the safe harbor.
Thus, for a farmer eligible for the cash method of accounting, the prior law current write-off rule for baby chicks and hens still applies. In addition, a current deduction is allowed (under the tangible property regulations) for the cost of tangible property that has an acquisition cost (or production cost) of $200 (per unit or per item) or less. That $200 amount should cover the cost of feeder pigs. The acquisition cost of other livestock purchased for resale, such as cattle, would also be currently deductible if the acquisition cost is within the $2,500 safe harbor.
Currently deducting the cost of livestock purchased for resale, if this is not an approach the taxpayer has previously taken, amounts to an accounting change requiring the filing of Form 3115. A full I.R.C. §481(a) adjustment will occur. I.R.C. §471(c)(4). The automatic change number is 235. However, this does not mean that IRS will grant audit protection for the change and even though the IRS grants consent to the change in how to account for livestock purchased for resale, that doesn’t mean it’s permissible and creates no presumption that it's a permissible method of accounting under a provision of the Code. See Rev. Proc. 2018-40, 2018-34 IRB 320.
The cash method of accounting allows the taxpayer to claim a deduction in the year the expense in incurred. However, there are some special situations in agriculture where the deduction is deferred. In addition, it is not presently known how the IRS will view the TCJA changes on this issue. Clearly, a farm taxpayer need not currently deduct the acquisition cost of items purchased for resale. The old rules can still be followed. But, if a current deduction is desired, there may be a way to accomplish that result.