Selling Farm Business Assets – Special Tax Treatment (Part Three)

Overview

Last week, in Part One, I discussed the basic structure and scope of I.R.C. §1231.  In Part Two, I continued the discussion with the definition of “livestock for purposes of I.R.C. §1231, the “holding period” requirement and the procedure for netting gains and losses, as well as the proper classification of unharvested crops that are sold with land.

Section 1231 also can be involved in transactions involving water rights, self-rents of livestock and timber.  Section 1231 transactions continued - it’s the topic of today’s post.

Does a Sale of Water Qualify?

Whether a sale of water qualifies for Section 1231 treatment depends on whether the seller retains a continuing interest in the water.  Vest v. Comr., 57 T.C. 128 (1971), aff’d., 481 F.2d 238 (5th Cir. 1973).  If the seller retains an economic interest, the gain on sale is treated as ordinary income. This includes, reserving the right to use water for livestock purposes where it does not amount to a sale of the water in place. Puckett v. Comr., T.C. Memo. 1964-40, aff’d., 355 F.2d 551 (5th Cir. 1966). 

In the Vest case, for example, the taxpayers owned land and associated water and mineral rights.  The Shell Oil Company (Shell) proposed to buy the water rights along with a right-of-way so that the water and mineral rights could more easily be developed.  The taxpayers entered into a contract with Shell to transfer the water rights to all water between 3,000 and 6,500 feet beneath their land.  The taxpayers reserved a sufficient quantity of water for their own exploration and production of minerals.  Ultimately, Shell paid the taxpayers over $26,000 for the water that it extracted and transported from the property of neighboring landowners.  The taxpayers reported the income as capital gain, but the IRS determined that it was ordinary income from a “lease.”  The Tax Court ruled against the IRS, determining that the transaction between the parties amounted to a sale of the water in place and a permanent interest in the property for a right-of-way. 

On further review, the appellate court noted that the transaction was not easy to categorize as it contained elements of both a lease and a sale.  Ultimately, however, the appellate court determined that the taxpayers had retained an economic interest in the water rights and the right-of way.  The taxpayers simply had not transferred to Shell all of the water in place or a specific quantity of it, and Shell controlled the conditions under which its obligation arose to make payment over a 75-year timeframe.  It had no duty to extract any “purchase price water” at all and, if it did not, the taxpayers would receive nothing.  This relationship between payment and production, the appellate court noted, meant that the taxpayers had retained an economic interest in the water rights that had been transferred to Shell and that the proceeds from the transaction were ordinary income. 

Note:   In Gladden v. Comr., 112 T.C. 209 (1999), the Tax Court held that the water rights that the petitioners relinquished in the Colorado River were capital assets because the allocation of the rights was directly linked to the capital investment in the land.  As such, the transaction amounted to a sale or exchange.

Self-Rental of Livestock – Converting Capital Gain to Ordinary Income?

What is the result when the taxpayer leases livestock that otherwise qualify for Section 1231 to an entity that the taxpayer owns?  Does Section 1231 tax treatment apply in some fashion?  In Dudden v. Comr., 893 F. 2d 174 (8th Cir 1990), the taxpayers (a married couple) were the sole shareholders of a farming corporation engaged in the trade or business of raising hogs.  They held title to brood sows and gilts (the breeding herd) and leased the animals to the corporation under a sow lease agreement.  Under the lease, the corporation was given possession of the breeding “sow” herd.  As noted, the taxpayers retained legal title to the sows and gilts.  Sows were kept for about two years (roughly five breedings) before the corporation culled them and returned them to the taxpayers.  When a sow was culled, one gilt was placed in the breeding herd as a replacement.  Title to the gilt remained with the taxpayers.  Thus, the breeding herd was constantly maintained at 150 sows. 

The taxpayers sold the culled sows (which were raised sows) and reported the gain as a Section 1231 gain, and took the position that the “lease” did not trigger gain because it was a mere bailment – title to replacement gilts never vested in the corporation and the corporation could not sell replacement gilts. The corporation was entitled to all pigs farrowed (whether gilt or barrow), except those designated as replacement gilts.  The corporation fed and cared for the replacement gilts until they reached a breeding weight of 220 pounds.  The gilts were then transferred to the taxpayers and the taxpayers raised them to a breeding weight of 270 pounds at which point the gilts were reintroduced in the breeding herd via a re-lease to the corporation.  A gilt pen was maintained where the replacement gilts were the ones that had superior genetics. 

The IRS disagreed with the taxpayers’ tax treatment of the transaction, claiming that the taxpayers received “rent” when a gilt was placed in the breeding herd as a beginning sow even though the taxpayers neither paid nor deducted any “rent” expense.  The amount of the rent, according to the IRS was the slaughter value of the gilt on the day of the placement in the breeding herd.  The taxpayer, according to the IRS then had basis in the gilt that could be depreciated over the next two years.  That deprecation, the IRS maintained, would be recaptured to the extent of the deprecation upon sale as a culled sow.  Thus, the IRS position was that the taxpayers were engaged in the trade or business of selling culled sows, the income from which should be reported on Schedule F.  The IRS took this position even though the selling of culled sows was not a major part of the taxpayers’ overall farming operation.  It merely served as a means of getting the taxpayers’ children into the farming operation without significant capital investment.

The Tax Court agreed with the IRS position.  Dudden v. Comr., 91 T.C. 642 (1988). 

The appellate court, while noting that the lease did have characteristics of a bailment, upheld the Tax Court’s determination that the taxpayers realized potential rental income when the corporation transferred the 220-pound replacement gilts to the taxpayers, and rental income when the gilts reached 270 pounds and were re-leased to the corporation.  That rental income, the appellate court held, should have been recognized when the gilts were reintroduced into the breeding herd and re-leased to the corporation.  The lease, the appellate court noted, provided a means by which the taxpayers could draw income from the corporation in the form of value from the replacement gilts that they didn’t initially possess and didn’t need to buy.  The appellate court pointed out that the lease stated that the transfer of replacement gilts constituted consideration for the lease – they were rent that the corporation “paid” in exchange for the right to use the taxpayers’ breeding herd, a breeding herd that the taxpayers held title to but didn’t have a current possessory interest in. 

The appellate court noted that rent is typically taxable as ordinary income upon receipt in the hands of a cash basis taxpayer.  I.R.C. §61(a)(5).  The appellate court took the position that, under the lease, the corporation held title to the gilts farrowed and title to the replacement gilts vested in the taxpayers when the 220-pound replacement gilts were acquired under the lease.  Based on this construction of the lease, there was a potential for realized income at this point in time.   It then followed, according to the appellate court, that when the replacement gilts reached 270 pounds (their breeding weight), the taxpayers actually realized rental income because they then had beneficial ownership (title, burden and expense).  As such, the lease was the same as a crop share lease with the taxpayers as landlords and rental income was recognized when the replacement gilts were re-leased to the corporation and reintroduced into the breeding herd.  That was the point in time when there was an addition to capital and livestock were reduced to money or an equivalent of money.  Thus, the appellate court reasoned, the crop-share recognition rule applied.  See Treas. Reg. §1.61-4(a)(5).  The money equivalent (ordinary income) of the rental income, the appellate court concluded, could be measured from the USDA price quotation sheets for slaughter value on the date when the taxpayers selected the replacement gilts.  Added to that amount would be the value of the corporation’s cost of providing food and care for the gilts while they were being prepared for breeding. 

Note:   The appellate court’s construction of the lease and computation of “rental income” is highly suspect.  The taxpayers maintained title to a replacement gilt from the time of birth.  There was no title transfer.  Possession was transferred, but that was no different than what occurred by the corporation’s use of the breeding herd.  In addition, the appellate court’s use of USDA price quotation sheets for slaughter value of gilts to peg the rental income is suspect.  A completely separate live market existed for the sale of gilts which yielded different (and more accurate) prices.

Special Rule for Timber

For timber farmers (those in the trade or business of harvesting and selling timber), the sale of the timber generates ordinary income. But, an election can be made by an owner of standing timber or a taxpayer that holds a contract right to cut timber (and has held the right for more than a year) to treat the cutting of timber as a sale or exchange that is eligible for capital gain treatment.  Id.  Via the election, the taxpayer gets capital gain treatment on the income in the value of the timber until it is cut.  A later sale generates ordinary income or loss. 

Capital gain treatment is also the result when a standing timber owner disposes of timber. I.R.C. §631(b). 

Christmas trees.  “Timber” includes evergreen trees if they are more than six years old at the time they are cut and are sold for ornamental purposes (e.g., Christmas Trees).  I.R.C. §631(a).  But, sale of Christmas trees on a “choose and cut” basis are not eligible for capital gain treatment.  Eck v. Comr., 99 T.C. 1 (1992); Rev. Rul., 77-229, 1977-2 C.B. 210.  Also, Christmas trees that are less than six years old at the time of cutting are not “timber” and are subject to the capitalization rules of I.R.C. §263A.  That means that all of the costs of raising the trees must be added to basis unless the taxpayer elects out of the application of the rules.  I.R.C. §263A(d)(3).  If the election is made, when the trees are sold the costs that would otherwise have been capitalized are subject to recapture as ordinary income and alternative depreciation is required.  I.R.C. §263A(e). 

Conclusion

Section 1231 assets are accorded special tax treatment under the Code.  For farmers and ranchers that treatment can come up in many common transactions.