Proper Tax Reporting of Breeding Fees for Farmers

Overview

Farmers and ranchers enter into numerous transactions during a tax year that pose interesting questions for tax preparers.  Sometimes those questions involve the proper tax reporting treatment of income received from various activities that are related to the farming or ranching business.  Examples include Income from breeding fees; mineral and soil sales; crop share rents; livestock sales; and income from the sale of farm business assets.

Proper tax reporting of certain income sources for farmers and ranchers – it’s the topic of today’s post

Breeding Fees

Income reporting.  Amounts that a farmer or rancher receives as breeding fees are includible in gross income.  If part or all of the fee is later refunded because the animal did not produce live offspring, the breeding fees are still reported as income in the year received, with an offsetting deduction when the refund is made.

Deduct or capitalize – who’s at risk?  Normally, if a farmer pays a fee to have his own cow serviced by someone else’s bull, the fee is a deductible on Schedule F as a breeding fee.  But, a breeding fee might be 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. Duggar v. Comr., 71 T.C. 147 (1978), 1979-2 C.B. 1; Jordan v. Comr., T.C. Memo. 2000-206.  For example, in Priv. Ltr. Rul. 8304020 (Oct. 22, 1982), a farmer bred cattle through an embryo transplant arrangement with a reproduction Center.  The only guarantee that the Center made was that an impregnated cow would become pregnant within 90 days of the transplant.  The famer assumed all of the risk of loss associated with the embryo and the resultant calf.  The IRS determined that the fee for the embryo transplanting service was not merely an additional cost of purchasing a calf.  Accordingly, the fee was not expended to acquire or improve a capital asset and was currently deductible (along with the cost of the embryo, the cost to prepare the recipient cow).  Again, the key to this tax result was that the Center made no guarantee that the farmer would eventually possess a live and healthy cow. 

Compare the result in Priv. Ltr. Rul. 8304020 (Oct. 22, 1982) with that of Rev. Rul. 79-176, 1979-1 C.B. 123.  Under the facts of Rev. Rul., 79-176, the taxpayer leased cows from a breeder under a breeding service agreement. Under the terms of the lease, the taxpayer was guaranteed a live calf, healthy and sound for breeding purposes, at the time of weaning. If the calf died or was not suitable for breeding, the breeder would replace the calf with one from its herd.  Based on these facts, the IRS concluded that the taxpayer could not deduct the cost under the breeding servicing agreement because the payments were capital expenditures. These facts were different, the IRS pointed out, from those of Duggar v. Comr., 71 T.C. 14 (1978), acq. 1979-2 C.B. 1.  In Duggar, under a three-part Cattle Management Agreement and Sublease, a farmer leased 40 brood cows for the purpose of building a herd of Simmental cattle.  Under a management agreement, he paid a lease fee and a fee for maintenance and care of the leased cows.  Under a separate management agreement, he paid a fee for the raising of his weaned female calves.  The Tax Court held that he could deduct the cost of maintenance and care associated with the raising of weaned calves to breeding age because he bore the risk of loss.  That was unlike the facts of Rev. Rul. 79-176, where the farmer didn’t bear any risk of loss until the calves were weaned.  That meant the costs incurred before weaning had to be capitalized as additional costs of the calves.  See also Wiener v. Comr., 58 T.C. 81 (1972), aff’d., 494 F.2d 691 (9th Cir. 1974); Maple v. Comr., 440 F.2d 1055 (9th Cir. 1971).  Similarly, in Jordan v. Comr., T.C. Memo. 2000-206, the petitioners were guaranteed live foals under stallion service contracts which resulted in the associated breeding fees being capitalized rather than deducted on Schedule F.

Note:  In Duggar, the farmer’s expenses associated with the leased brood cows were nondeductible capital expenditures. The agreement was in effect for the purchase of weaned calves.

The bottom line is that a breeding fee is classified as either a cost of "raising" or a cost of "acquiring" an animal depending upon which party bears the risk of loss that the breeding process is unsuccessful.

Purchase of impregnated cows.  In Rev. Rul. 86-24, 1986-1 C.B. 80, a corporation owned purebred cows that, after hormone treatments, were artificially inseminated with semen from a purebred bull.  The embryos were surgically removed and implanted in the non-purebred cows.  After a positive pregnancy test, the corporation offered the implanted cows for public sale.  The cows were usually resold after giving birth to purebred calves.  The purchase price of each cow impregnated with an embryo transplant was equal to its fair market value (which was about three times greater than the fair market value of a cow not so impregnated.  The sale price of a cow after it gave birth to a purebred calf was equal to that of a non-impregnated cow.  The taxpayer (cash basis, calendar year) bought 10 impregnated cows and allocated the entire purchase price to the cows, and none to the purebred embryos.  Later in the tax year, 10 purebred calves were born (which the taxpayer intended to hold for sale) and the taxpayer then sold the cows for about one-third of what they were purchased for.  The taxpayer wanted to claim an ordinary loss with respect to the sale of the cows

The IRS determined that the purchase price of the impregnated cows had to be allocated to each cow and its embryo on the basis of the fair market value of each.  The eventual sale of the cows (within 24 months of their acquisition) would trigger ordinary income or loss.  However, because the taxpayer sold the cows for the same amount of cost that had to be allocated to them, there was no gain or loss on the sale of the cows.   The balance of the acquisition cost of the impregnated cows was allocated to the embryos was determined to be an amount expended in purchasing livestock that had to be capitalized.  The calves were not capital asset because they were held primarily for sale to customers in the ordinary course of business.  Thus, any gain or loss on their eventual sale would be ordinary in nature.  Neither the cost of the cows nor the basis allocated to the calves was currently deductible on Schedule F as a business expense. 

Note:  In Rev. Rul, 87-105, 1987-2 C.B. 46, the IRS modified Rev. Rul. 86-24 by stating that if before Feb. 24, 1986, the taxpayer had purchased a cow that was pregnant with a transplanted embryo or was subject to a binding written agreement to buy an impregnated cow, the cost allocated to the embryo can be deducted as a business expense under I.R.C. §162. 

Accrual method.  For a farmer on the accrual method of accounting, breeding fees are to be capitalized and allocated to the cost basis of the animal.  G.C.M. 39519 (Oct. 11, 1985).  Under the facts of the G.C.M., the taxpayer was trying to establish a breeding herd, and purchased cattle embryos and recipient cows.  The farmer and the seller allocated costs separately to breeding, embryo transplant, and maintenance services, and to the purchase price of the cows.  The question was whether the cost of the embryo transplants were deductible under I.R.C. §162 or had to be capitalized under I.R.C. §263.  The IRS concluded that the expense incurred for each embryo transplant was to be capitalized as the cost of acquiring a capital asset (the embryo) and, hence, was to be included in the cost basis of each cow. 

Conclusion

Breeding fees can generally be deducted as a farm business expense. However, if the breeder guarantees live offspring as a result of the breeding or other veterinary procedure, the fees must be capitalized into the cost basis of the offspring. For a taxpayer on the accrual method of accounting, breeding fees must be capitalized and allocated to the cost basis of the offspring.