Friday, August 23, 2019
Farmers have various sources of income. Of course, grain sales and livestock sales are common and the tax rules on the treatment of such sales are generally well understood. Farmers also have other miscellaneous sources of income from such things as the sale of timber and soil and natural resources. Another source of income for some farmers and ranchers is from breeding fees.
The proper tax reporting of income from breeding fees – it’s the topic of today’s post.
Sale or Lease?
Perhaps the starting point in determining the proper tax treatment of breeding fees from the perspective of both the buyer and the seller is to properly analyze the transaction that the parties have entered into. The key question is whether a breeding fee arrangement is a lease or a sale. This is not only important from a tax standpoint, but also from a financing and secured transaction standpoint. See, e.g., In re Joy, 169 B.R. 931 (Bankr. D. Neb 1994).
The courts and the IRS have, at least to a small extent, dealt with the proper tax treatment of breeding fees. A breeding or stud fee is classified as either a cost of raising or a cost of acquiring an animal, depending on which party bears the risk of loss that the breeding process may be unsuccessful. See, e.g., Jordan v. Comr., T.C. Memo. 2000-206. For example, in Duggar v. Comr., 71 T.C. 147 (1978), acq., 1979-1 C.B. 1, the petitioner entered into a “management agreement” with a cattle breeder. Under the agreement, the petitioner leased 40 brood cows and paid a fee for the artificial insemination of each brood cow as the initial step in developing a purebred herd. The agreement specified that the petitioner owned each calf at the time of birth, but did not have possession of any particular calf until after weaning – about a year after birth. The petitioner also paid a “calf maintenance” fee for each calf until the calf was weaned. After weaning and gaining possession of a calf, the petitioner could either sell the calf or pay an additional annual maintenance fee to the cattle breeder for the care of the heifers during the pre-breeding timeframe.
On his tax return, the petitioner deducted the cost of leasing the cows and maintenance fee associated with each calf for both the pre-weaning and pre-breeding stages. The IRS denied the deductions and the Tax Court agreed. The Tax Court concluded that the transaction between the petitioner and the cattle breeder was essentially the purchase of weaned calves. It couldn’t be properly characterized as the rental and care of breeding cows because the risk of loss with respect to any particular calf didn’t pass to the petitioner until after the calf was weaned. Thus, the costs that the petitioner incurred for the leasing of the cows and the maintenance of the calves before weaning had to be capitalized. However, the Tax Court did conclude that the expenses that the petitioner incurred to maintain the calves post-weaning were currently deductible.
Shortly after the Tax Court decided Duggar, the IRS issued a Revenue Ruling on the subject. The facts of the ruling are similar to those of Duggar. In Rev. Rul. 79-176, 1979-1 C.B. 123, a taxpayer on the cash method of accounting entered into a cattle breeding service agreement with another party. The agreement was specifically referred to as a lease. The agreement specified that the taxpayer “leased” cows from the herd owner. Under the agreement, any calf that was produced within a year of mating was to remain with its mother for a year after birth. When a calf was weaned the agreement termination and the calf was to be healthy and ready for breeding. Only after a calf was weaned did the taxpayer gain possession of the calf. Upon gaining possession, the taxpayer could sell the calf or place it in a herd management program.
Based on these facts, the IRS took the position that the arrangement amounted to a sales contract for the purchase of a live calf. Thus, the costs attributable to the cattle breeding, including the breeding fee and the initial cost of caring for the cow and calf until the calf was weaned, were non-deductible capital expenditures under I.R.C. §263. The calf could be depreciated over its useful life.
In contrast to the facts of Duggar and Rev. Rul. 79-176, if a taxpayer pays a breeding fee an animal bred that the taxpayer owns, the fee is deductible.
For a taxpayer that is on accrual accounting, breeding fees must be capitalized and allocated to the cost basis of the animal.
What About Embryo Transplanting?
An amount paid for embryo transplanting, including the cost of buying the embryo and costs associated with preparing the animal for transplantation and the transplant fees are deductible as “breeding fees.” Priv. Ltr. Rul. 8304020 (Oct. 22, 1982). But, if the taxpayer buys a pregnant cow the purchase price is to be allocated to the basis of the cow and resulting calf in accordance with the fair market value of the cow and the calf. In this situation, there is no current deduction for the purchase price of the cow or the portion of basis that is allocated to the calf.
What About the Owner of the Breeding Cattle?
Neither the Tax Court in Duggar, nor the IRS in Rev. Rul. 79-176 discussed the tax consequences to the owner of the breeding cattle. But, as noted above, both the Tax Court and the IRS treated that transactions involved as a sale. Because of that characterization, the owner of the breeding cattle should treat receipt of breeding fees as income from the sale of calves. If part of all of the fee is later refunded because the animal did not produce live offspring (or for any other reason) any breeding fees received should still be treated as income in the year received with a later deduction for the year that a refund is made.
Farmers and ranchers generate income in unique ways. Breeding fees arrangements are just one of those ways. Most likely, any such arrangement should be treated as a sale on the tax return. But, as noted, the correct answer is highly fact dependent.