Estate of Wallace v. C.I.R.

• Decision Date: 13 July 1992
• Docket Number: No. 91-7318,91-7318
• Parties: -5349, 92-2 USTC P 50,387 ESTATE OF Gerald L. WALLACE, Deceased, Celia A. Wallace, Executrix, and Celia A. Wallace, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 1038

965 F.2d 1038

70 A.F.T.R.2d 92-5349, 92-2 USTC P 50,387

ESTATE OF Gerald L. WALLACE, Deceased, Celia A. Wallace,

Executrix, and Celia A. Wallace, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 91-7318.

United States Court of Appeals, Eleventh Circuit.

July 13, 1992.

Roland J. Mestayer, Jr., Megehee, Mestayer, Kinard & Smith, P.A., Pasacagoula, Miss., Norman A. Lofgren, Clark S. Willingham, Mankoff, Hill, Held & Goldburg, P.C., Dallas, Tex., for petitioners-appellants.

Robert D. Forrester, Gibson, Ochsner & Adkins, L.L.P., Amarillo, Tex., for amicus.

Abraham N.M. Shashy, Jr., Chief Counsel, I.R.S., Gary R. Allen, Chief, Joan J. Oppenheimer, Brian C. Griffin, Appellate Section, Tax Div., Washington, D.C., for respondent-appellee.

Appeal from a Decision of the United States Tax Court.

Before KRAVITCH and DUBINA, Circuit Judges, and RONEY, Senior Circuit Judge.

KRAVITCH, Circuit Judge:

Plaintiffs-Appellants Gerald L. Wallace ("Wallace"), deceased, and Celia A. Wallace, his wife and executrix, appeal from a tax court decision upholding the IRS's finding of tax deficiencies against the Wallaces for the years 1980 and 1983. The tax court ruled that the Wallaces were not entitled to deduct the entire cost of feed for their cattle-feeding business in the year in which the feed was purchased, and could only deduct the cost in the year the feed was actually consumed because, under 26 U.S.C. § 464, Wallace was a limited entrepreneur who did not "actively participate" in the management of his cattle-feeding enterprise. We affirm.

BACKGROUND

Wallace, who died in 1986, was a physician who throughout his medical career also engaged in a number of successful business and investment ventures. ¹ These ventures included developing residential property in St. Thomas, the American Virgin Islands; purchasing land in Mobile County, Alabama on which a producing oil well was drilled; constructing a hospital, a medical office building, and a nursing home in Mobile County; building an office building and schools in Baldwin County, Alabama; engaging in the commercial fishing business through the ownership of shrimp In 1979, with no background in farming, Wallace became involved in the cattle-feeding business. He engaged in the business continuously from 1980 to 1985, taking out loans to finance the venture and reinvesting profits in more cattle. According to the tax court, "The term 'cattle feeding' applies to the practice of placing cattle in feedlots, feeding the cattle a high protein diet for 3 to 5 months, and then selling the cattle for slaughter." Estate of Wallace v. Commissioner, 95 T.C. 525, 529 (1990). The tax court found that:

boats; operating a natural gas transmission company; and owning a hotel.

[t]he feedlot employees include the feedlot manager, clerical staff, office manager, cowboy-foreman, cowboys, lay doctor, processors, market monitors, and a food mill expert. In addition to employees, a commercial feedlot usually has a nutritionist and a veterinarian as consultants.

The feedlot employees care for the cattle from the moment the cattle are delivered to the feedlot until the moment they are sold for slaughter. Care of the cattle includes daily feeding, maintenance of the cattle's health, treatment of disease, and other activities necessary for the cattle to adequately gain weight during the feeding period. Cattle in the feedlot are segregated into separate pens according to owner, but all cattle in the feedlot at a given time and at a given stage of development are treated exactly the same.

The ultimate authority in a commercial feedlot is the feedlot manager. The feedlot manager and supervisors make all the decisions regarding the hiring and firing of employees on the feedlot. Individual cattle owners have no authority to hire or fire any employees. If an owner is displeased with the treatment his cattle receive at a particular feedlot, he can speak with the feedlot manager or operator in an attempt to work out a solution, take his complaint to arbitration or to court, or simply move his cattle to another feedlot. Generally, if the owner is dissatisfied with a feedlot, when he purchases his next set of cattle he will place those cattle with another feedlot. It is considered very unusual to move cattle from one feedlot to another during their feeding cycle, because it throws the cattle off feed and adds freight charges.

Commercial feedlots offer cattle owners marketing services. The feedlot will place fat cattle on a show list for viewing by packers/buyers who usually visit the feedlots daily. In many instances, the feedlot manager will negotiate a sale of cattle to the packer/buyer from the cattle owner.

Wallace, 95 T.C. at 529-30. The majority of cattle in the United States are fed in commercial feedlots. ² Whether the owners of the cattle are doctors living hundreds of miles away or ranchers living nearby, they have no control over how the feedlot is operated.

Cattle feeding has been engaged in by cow-calf producers, stocker-operators, and others interested in the business largely for its profit potential. Cattle feeding also has been well known as a tax deferral shelter for professionals and other high-income individuals, who took advantage of a special tax rule allowing farmers to deduct the entire cost of certain expenses, such as cattle feed, in the year purchased, rather than in the year consumed. Wealthy taxpayers used this special tax rule to prepay farm expenses and take large deductions against nonfarm income in the first year, and in subsequent years, of a farming venture. Congress enacted 26 U.S.C. § 464 in 1976 to exclude farming syndicates from this special tax advantage. The Senate Report of the Committee on Finance for the Tax Reform Act of 1976 explained that:

[u]nder present law [before the passage of section 464], farm operations are governed by special tax rules, many of which confer tax benefits on farming activities and on persons who engaged in farming. Under present law [before section 464], the special tax rules available to farmers The Treasury has also long permitted farmers to deduct currently many of the costs of raising or growing farm assets ... which are used in the trade or business of farming. (In similar nonfarming businesses, such as manufacturing, these costs generally are treated as capital expenditures and are depreciated over their useful lives.)

                can be utilized by both full-time farmers and by high-bracket taxpayers who participate in farming as a sideline....  The special inventory exception for farmers was adopted by administrative regulation more than fifty years ago.   The primary justification for this exception was the relative simplicity of the cash method of accounting which, for example, eliminates the need to identify specific costs incurred in raising particular animals
                

S.Rep. No. 938, 94th Cong., 2d Sess. 51-52 (1976), reprinted in 1976 U.S.C.C.A.N. 2897, 3439, 3487, 3488 (footnotes omitted). ³

In 1980, the year Wallace entered the cattle-feeding business, his tax return showed nonfarm income in excess of $1,000,000. Wallace deducted $473,000 in farm losses, the great majority of which was the cost of prepaid cattle feed to be used in future years, lowering his adjusted gross income to $654,000. In 1983, Wallace earned in excess of $2,800,000 in nonfarm income and deducted roughly $1,500,000 in farm losses, again mostly for prepaid feed, lowering his adjusted gross income to roughly $1,400,000. Citing 26 U.S.C. § 464, the IRS disallowed most of these deductions.

The House and Senate Reports for the Tax Reform Act of 1976 discussed some of the characteristics of cattle feeding as a tax deferral shelter that led to passage of section 464:

Cattle feeding offers one of the best known and, until recent downturns in the farm economy, most widely used deferral shelters. Typically, the investment is organized as a limited partnership or as an agency relationship (under a management contract) in which a commercial feedlot or a promoter agrees to act as an agent for the investor in buying, feeding and managing cattle. After being fed a specialized diet for four to six months, the fattened cattle are sold at public auction to meat packers or food companies. A cattle feeding venture of this kind is typically formed in November or December, using leveraging and the cash method of accounting to permit taxpayers with income from other sources to defer taxes otherwise due on that income in that year by deducting expenses for prepaid feed, interest, and other costs incurred in the feeding venture. Income is realized in the following year when the fattened cattle are sold. At that time, the bank loans are repaid and any unpaid fees due the feedlot (or promoter) are deducted. The balance is distributed to the investors. Since feeder cattle are held for sale to customers, sale of the animals produce ordinary income. If the investors were to reinvest their profit from one feeding cycle into another one, they could theoretically defer taxes indefinitely on the nonfarm income which they sheltered originally.

Since most investors in cattle feeding shelters buy in at the end of the calendar year, deductions for prepaid feed for the cattle have been central to the creation of tax losses in that year.

S.Rep. No. 938, 94th Cong., 2d Sess. 56 (1976), reprinted in 1976 U.S.C.C.A.N. 2897, 3439, 3492; H.Rep. No. 658, 94th Cong., 1st Sess. 42 (1975), reprinted in 1976 U.S.C.C.A.N. 2897, 2936 (footnote omitted.) ⁴

After Wallace decided to enter the cattle-feeding business, he hired Joe Haynes ("Haynes") to advise him. Haynes advised several clients in the business. Haynes's Wallace did, however, have some contact with the feeding end of the business. On one occasion he moved cattle from one feedlot to another during the feeding cycle--a move considered unusual because of the extra expense involved--due to...