Sunday, March 7, 2021
In general, gains and losses arising from the sale of farmland, depreciable assets used in the farm business, draft, breeding, dairy and sporting livestock, unharvested crops sold with the land, and some other transactions receive a special form of tax treatment. This is a very advantageous tax treatment for farmers and ranchers. The section of the Internal Revenue Code involved is I.R.C. §1231, and assets that receive this special tax treatment are known as “Section 1231” assets.
In today’s Part One of a Two-Part series, I discuss the basic structure and scope of Section 1231. Later this week, in Part Two, I will take a look at the definition of “livestock,” the “holding period,” the procedure for netting gains and losses, and some other special situations involving Section 1231 assets.
The unique tax treatment of “Section 1231” assets for farmers and ranchers, Part One of a Two-Part series – it’s the topic of today’s post.
Upon the sale or exchange of Section 1231 property, the result is either capital gain or ordinary loss. Net gains from the sale of Section 1231 assets are long-term capital gains. As such, they are taxed at favorable rates. Presently, long-term capital gains are taxed at the rate of zero percent, 15 percent, or 20 percent, depending on a combination of the taxpayer’s taxable income and marital status. For a husband and wife filing jointly, the 20 percent rate kicks-in at an income above $501,600. The capital gain rate for a married couple filing jointly is zero up to an income level of $80,800.
If the losses on Section 1231 transactions exceed the gains, the net loss is treated as an ordinary loss. That’s also a favorable outcome for the taxpayer.
This favorable tax treatment, however, can only be achieved if all of the eligibility requirements for I.R.C. §1231 are satisfied.
What is Section 1231 Property – The “Scope” Question
The “use” issue – burden of proof. To be Section 1231 property, the property must be used in the taxpayer’s trade or business. I.R.C. §1231(b). The property cannot be held for sale to customers. The property must also be subject to depreciation and held for more than one year. I.R.C. §1231(b)(1). Real property also qualifies if it is used in the taxpayer’s trade or business and held for more than a year. Id. But, property is not Section 1231 property if it is inventory property; property held primarily for sale to customers in the ordinary course of business; a copyright, literary, musical or artistic composition or a U.S. government publication. I.R.C. §§1231(b)(1)(C-D). The taxpayer bears the burden to establish that property qualifies as Section 1231 property. For instance, in Gettings v. Comr., T.C. Memo. 1988-328, the court held that sales of cattle were not eligible for capital gain treatment because the taxpayer couldn’t prove that the cattle were not held for sale to customers in the ordinary course of business or that the cattle were depreciable assets. The Tax Court pointed out that the taxpayer considered all of his cattle as available for sale at any time.
By statute, Section 1231 assets include timber, coal and iron ore (I.R.C. §1231(b)(2)); cattle and horses that the taxpayer holds for draft, dairy or sporting purposes that are held for 24 months or more from the date of acquisition (I.R.C. §1231(b)(3)(A)); other livestock that is held for draft, dairy or sporting purposes that are held for 12 months or more (I.R.C. §1231(b)(3)(B)); and unharvested crops on land that used in the taxpayer’s trade or business and held for more than one year if the crop and the land are sold or exchanged (or compulsorily or involuntarily converted at the same time to the same person). I.R.C. §1231(b)(4). Poultry is not “livestock” for purposes of I.R.C. §1231.
Determining use. The requirement that the asset be held for use in the taxpayer’s trade or business (I.R.C. §1231(a)) is key. Income from the sale of assets that are held “primarily for sale to customers in the ordinary course of business” do not receive Section 1231 treatment. The regulations and the courts point out that the reason or purpose for which a taxpayer “holds” and animal is based on the facts. A key fact in that determination is how the taxpayer uses any particular animal. Thus, an animal that is held for ultimate sale to customers in the ordinary course of the taxpayer’s business may still be deemed to be held for draft, dairy or breeding purposes. Treas. Reg. §1.1231-2(b)(1). The examples in the regulations under Treas. Reg. §1.1231-2(b)(2) are very helpful illustrations of how the use of an animal impacts eligibility for Section 1231 treatment.
The caselaw is also helpful in defining the scope of Section 1231. In Contra Biltmore Co. v. United States, 129 F. Supp. 366 (W.D.N.C. 1955), aff’d., 228 F.2d 9 (4th Cir. 1955), the issue was whether bull-calves between six and eleven months of age, and heifer-calves between six and twenty-four months old raised and sold by a dairy cattle herder, were 'property held primarily for sale to customers or were property used in the taxpayer’s trade or business. The IRS prevailed on its argument that bulls and heifers that were sold before they reached the age of productivity were not Section 1231 assets even though the taxpayer retained them as standby replacements. Likewise, calves of a producing herd have been held to not constitute section 1231 property. Fox v. Comr., 198 F.2d 719 (4th Cir. 1952). The court determined that the calves were the production of Section 1231 property. In Bandes v. Comr., T.C. Memo. 1982-355, the issue was whether the sale of pregnant gilts were properly characterized as long-term capital gain under I.R.C. §1231. The taxpayer retained two females from each litter for breeding purposes. The Tax Court disallowed Section 1231 treatment upon a finding that the taxpayers did not intend to hold the gilts for breeding purposes. Instead, the Tax Court determined that the taxpayer was attempting to convert ordinary income to capital gain through the operation of Section 1231. Facts matter.
For farmers that maintain a breeding herd the herd is often culled of unfit animals. The sale of culled cows, for example, can qualify for Section 1231 treatment if the farmer can show that the culled cows were no longer suitable for breeding purposes or at least different from those livestock that were not sold. The motive to cull is controlling rather than when the culling occurred or how the animals were culled. But, if heifers are culled shortly before the annual spring sale, that could cause the IRS to question the purpose for which the heifers are held. See, e.g., Hillman v. United States, 2002-2 U.S.T.C. para. 50,700 (D. S.D. 2002). If the facts indicate that that taxpayer was in the business of selling breeding stock, a court is likely to deny section 1231 treatment for the culled animals. See, e.g., A. Duda & Sons, Inc. v. United States, 560 F.2d 669 (5th Cir. 1977), rev’g., 383 F. Supp. 1303 (M.D. Fla. 1974). Be careful in promoting and marketing the sale of the culled animals! You don’t want to be too visible. In addition, the IRS could asset self-employment tax on the sale proceeds. Again, relevant to that determination is the degree of marketing and promotion of the annual spring sale.
Other situations. An animal can still be determined to be held for a breeding purpose if it is disposed of within a reasonable time after its intended use is prevented or made undesirable by reason of accident, disease, unfitness or something similar. Treas. Reg. §1.1231-2(b)(1). Also, if the taxpayer’s plans change and animals must be sold, Section 1231 treatment might be proper. See, e.g., Coldwater Cattle Co. v. United States, No. 2756-Civil, 1961 U.S. Dist. LEXIS 5430 (N.D. Tex. Jan. 9, 1961); Clingman v. United States, No. F-75-194 Civ., 1977 U.S. Dist. LEXIS 17033 (E.D. Cal. Mar. 7, 1977). Similarly, weather can play a role. In Carter v. Comr., 257 F2d 595 (5th Cir. 1958), the taxpayer bought heifers to start a breeding herd but sold them shortly thereafter because weather conditions made feeding difficult. The court held that Section 1231 treatment was available for the sale of the heifers.
With respect to the sale of pregnant breeding stock, the question is whether an allocation of a portion of the selling price must be made to the unborn young? The Tax Court has said that no allocation is required. In Metz v. United States, No. 1446, 1962 U.S. Dist. LEXIS 5176 (E.D. Ky. Mar. 27, 1962), the Tax Court reasoned that allocation was not required to an unborn because of the uncertainty of a successful birth.
For horses, if a horse is held for racing purposes (e.g., for racing at a public track or a horse trained for racing purposes) the regulations, in general, consider the horse to be held for sporting purposes. Treas. Reg. §§1.1231-2(c)(1) & (c)(1)(i). But, if a horse has never been raced or trained for racing, it would likely not be considered to be held for racing purposes. Horses used for team roping may present a problem for the taxpayer in establishing the existence of a trade or business - a prerequisite for Section 1231 treatment. See, e.g., Gallegos v. Comr., T.C. Memo. 2021-25. A colt that isn’t fit for sporting purposes can still qualify for section 1231 treatment even if it hasn’t been trained very much or raced. For instance, in Kirk v. Comr., 47 T.C. 177 (1966), acq., 1967-1 C.B. 2, the Tax Court held that horses that had been culled because they weren’t adequate for use a harness horses in the hands of a professional harness racer qualified for Section 1231 treatment.
In Bradshaw v. United States, No. 2154, 1971 U.S. Dist. LEXIS 10564 (E.D. Ky. Dec. 1, 1971), the plaintiff kept approximately four stallions and 35 mares for breeding. Normally about 25 foals were born each year. After weaning in the fall, the plaintiff culled the foals and sold them at public auction before training them. The plaintiff reported the gain as ordinary income. The rest of the yearlings were broken to bridal and lead. Throughout the training process, some of the horses were determined to be undesirable for showing or breeding. These horses continued to train, but they were classified as “cull” and sold at private sales. The IRS claimed that the plaintiff was in the business of selling show horses and that if a buyer wanted to purchase any horse on his farm, he would sell the horse and report the gain as long-term capital gain. The horses that the plaintiff sold included mares, stallions and geldings. Geldings cannot be used for breeding purposes, so the plaintiff relied on the general provisions of I.R.C. § 1231(b)(1) (an asset used in the trade or business that is subject to depreciation and has been held for more than one year) rather than the more specific provisions of I.R.C. §1231(b)(3) (the provision for livestock). The court cited the Kirk case for the proposition that the existence of the (b)(3) did not preclude the horses from qualifying under the general provisions of (b)(1). The IRS did not appeal, but issued an Action on Decision stating that the decision was probably wrong because the horses sold were not segregated from the remaining horses, but were kept in training and sold only when buyers selected them from purchase. However, the IRS noted that the jury verdict was not clearly erroneous. 1971 AOD LEXIS 486 (Dec. 10, 1971).
For embryo transplants, the animal from which the embryo came is the section 1231 asset – it is deemed to be held for breeding purposes. Rev. Rul. 86-24, 1986-1 C.B. 80; Treas. Reg. §1.1231-2(b)(1). When the cow in which the implanted embryo is purchased, the purchase price is to be allocated between the cow and the embryo of the basis of the fair market value of each. The cost allocated to the embryo is capitalized. The resulting calves that are born from the embryo implantation will trigger ordinary income (or loss) on sale if they are held for sale to customers in the ordinary course of business. With respect to embryo transplant services, however, the IRS is on the look-out for sham transactions. Investments in cattle breeding operations may be suspect from the IRS standpoint. The transaction must have economic substance. If not, the IRS will disregard the transaction. See, e.g., In re Gran, 964 F.2d 822 (8th Cir. 1992); Boyer v. Comr., T.C. Memo. 1992-724.
In Part Two, I will continue the discussion of other aspects of Section 1231. It’s a unique and beneficial part of the Code for farmers and ranchers.