Rojas v. Comm'r of Internal Revenue

• Decision Date: 25 May 1988
• Docket Number: 24064-82.,Docket Nos. 24029-82
• Citation: 90 T.C. 1090,90 T.C. No. 73
• Parties: DOROTHY SCHWARTZ ROJAS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

90 T.C. 1090

90 T.C. No. 73

DOROTHY SCHWARTZ ROJAS, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 24029-82

24064-82.

United States Tax Court

Filed May 25, 1988

D and E are the transferees and former majority shareholders of S, a corporation that had been engaged in the business of farming row crops. S adopted a plan of complete liquidation and pursuant to that plan distributed to its majority shareholders all its operating assets, including certain harvested and unharvested crops. Prior to the liquidation, S had deducted, pursuant to I.R.C. section 162(a), expenses incurred in connection with the cost of cultivating these crops.

HELD, the tax benefit rule does not require S to include in income the expenses deducted for materials and services which were used and consumed prior to the liquidation in the cultivation of the crops. Hillsboro National Bank v. Commissioner and United States v. Bliss Dairy, Inc., 460 U.S. 370 (1983), applied. Craig A. Houghton, for the petitioner in docket No. 24029-82.

Robert L. Sullivan, Jr., for the petitioners in docket No. 24064-82.

M. Kendall Williams, for the respondent.

OPINION

WHALEN, Judge^*:

Respondent determined deficiencies in the Federal income tax of petitioner Schwartz Farms, Inc., in the following amounts:

+------------------------+
                ¦TYE Jan. 31— ¦Deficiency¦
                +-------------+----------¦
                ¦1975         ¦$1,782    ¦
                +-------------+----------¦
                ¦1977         ¦742,222   ¦
                +-------------+----------¦
                ¦1978         ¦284,256   ¦
                +-------------+----------¦
                ¦Total        ¦1,028,260 ¦
                +------------------------+
                

Respondent also determined that petitioners, Dorothy Schwartz Rojas and the Estate of Charles R. Schwartz, Deceased, were liable for such amount as transferees. ¹

These cases were consolidated for trial, briefing and opinion. After concessions, the only issue for decision is whether the tax benefit rule requires Schwartz Farms, Inc., to report as income the amount which it deducted as expenses for materials and supplies which it used and consumed in connection with the cultivation of crops prior to its liquidation and the distribution of the crops to its shareholders.

All the facts have been stipulated. The stipulation of facts and attached exhibits are incorporated herein by this reference. ²

It appears that the taxpayer in Ballou Construction did not raise the issue before us here, i.e., whether the tax-benefit rule can be applied to cancel out business deductions for materials and services which are consumed in the business before a liquidating distribution. In fact, the court treated the ‘sand deposit in place‘ as the equivalent of the unconsumed feed in Bliss Dairy. The court stated as follows:

The premise of a deduction under section 162(a) is that an expensed asset will be consumed by the taxpayer in his trade or business. Salina Sand's later distribution was an inconsistent event with the deduction for two reasons. First, the taxpayer who sells rather than consumes an expensed asset will lose the deduction because the full amount of the proceeds must be recognized. Second, Salina Sand's distribution of the ‘Sand Deposit in Place‘ to its shareholder ‘turns the expensed asset to the analog of personal consumption ‘ and thus the assumption underlying the original deduction is proven invalid.

It is clear that the court simply applied the logic of the Supreme Court in Bliss Dairy to the facts before it on the assumption that the deducted costs were directly attributable to the sand deposit in place, an asset which had not been consumed. The court was not called upon to consider the issue in this case. Moreover, the language quoted above provides no support for respondent's position in this case that deductions under section 162(a) are premised on the sale of the product produced, rather than on consumption of the expensed asset in the taxpayer's business.

Historically, farmers have had the option of using the cash method of accounting without the need to accumulate inventories or to use the inventory method of accounting. Section 39.22(c)-6(a), Regs. 118; section 1.471-6(a), Income Tax Regs.; section 1.61-4, Income Tax Regs.; Hi-Plains Enterprises, Inc. v. Commissioner, 80 T.C. 158 (1973), affd. 496 F.2d 520 (10th Cir. 1974). A cursory review of certain farm tax provisions shows that Congress intended to provide farmers with ‘more liberal accounting rules than those generally applicable in the case of other types of business activities. ‘ H. Rept. 91-413 (Part 1), at 62 (1969), 1969-3 C.B. 240; S. Rept. 94- 938, at 52 (1976), 1976-3 C.B. (Vol. 3) 90. Congress also recognized that the special farm accounting rules required no matching of deductions and income and, therefore, contemplated that distortions would result. For example, in connection with its passage of section 207(a) of the Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1536, adding section 464 to the Code, the Senate Report, S. Rept. 94-938, supra at 53-54, 1976-3 C.B. (Vol. 3) at 91-92, states as follows:

Farm investments offer an opportunity to defer taxes on nonfarm income where investors can take advantage of the special farm tax rules to deduct farm expenses in a year or years prior to the years when the revenue associated with such expenses is earned. This type of deferral can occur regardless of whether the proceeds from the later sale of the underlying products are taxed at ordinary income or capital gain rates. Generally, in farming operations tax losses can be shown in early years of an investment because of (1) the opportunity to deduct, when paid, costs which in nonfarm businesses would be inventoried and deducted in a later year, (2) the ability to deduct, when paid, costs which should properly be capitalized, and (3) the ability to claim depreciation deductions which exceed straight-line depreciation.

These tax losses may offset income from a taxpayer's other nonfarm occupations or investments on which he would otherwise have to pay tax currently. When the income which is related to these deductions is reported, it will not be reduced by the amount of the deductions properly attributable to it (and will thus be greater in net amount than it otherwise would be). This lack of matching results in deferral of taxes from the years when the initial deductions were taken. If the related farm income is eventually realized as capital gain (as it may be where breeding animals or orchards are sold), conversion of ordinary income (against which the expenses were deducted) into capital gain may also result. Even without the possibility of conversion, however, the tax advantages of deferral alone are frequently sufficient to motivate many high-income taxpayers to engage in certain types of farming activities.

Through the years, Congress has imposed some limits on the use of the special farm accounting provisions in the case of farm syndicates and the like but, as recognized during passage of the Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085, ‘Most farmers use the cash method of accounting, and therefore do not maintain inventories or capitalize preproductive period costs (i.e., costs incurred prior to the time a plant or animal becomes productive). ‘ H. Rept. 99-841 (Conf.), at II-112 (1986), 1986-3 C.B. (Vol. 4) 112.

It would appear, therefore, that Congress intended to allow farm businesses, like Schwartz Farms, Inc., to deduct crop costs without the necessity of matching such costs against the income which would be realized from the sale of the crops themselves. Nevertheless, respondent's position in this case is that the crop costs which are otherwise deductible under section 162 at the time paid should be ‘inventoried‘ and recaptured in the event there is no business sale of the crop produced. We agree that Bliss Dairy requires recapture with respect to any farm materials on hand at the time of a liquidation but we fail to see that the tax benefit rule requires the cost of materials and supplies consumed in the farm business to be recaptured in this case, in view of the clear legislative intent to allow most farmers to dispense with the need to accumulate inventories. Cf. Rev. Rul. 85-186, 1985-2 C.B. 84, where respondent recognized that application of the tax benefit rule to deductions for research and experimentation under section 174(a) was inappropriate in view of clear legislative intent to relieve taxpayers of the obligation to allocate costs between amounts currently deductible and amounts required to be capitalized.

Decisions will be entered under Rule 155.

Reviewed by the Court.

STERRETT, WHITAKER, KORNER, COHEN, CLAPP, SWIFT, WRIGHT, WILLIAMS, and WELLS, JJ., agree with the majority opinion.

GERBER, J., did not participate in the consideration of this opinion.

NIMS, J., DISSENTING:

I respectfully dissent. By its action in this case the majority reopens a loophole which the Supreme Court thought it had closed in Hillsboro National Bank v. Commissioner and United States v. Bliss Dairy, Inc., 460 U.S. 370 (1983). This arises through the combination of allowance of corporate deductions under section 162 for the cost of materials and supplies, plus the step-up in basis of the corporate assets distributed in liquidation by virtue of former section 337 which are thereafter sold by the shareholders at little or no gain. This result is not only inconsistent with Bliss Dairy; it also conflicts directly with our recent holding in Byrd, Transferee v. Commissioner, 87 T.C. 830 (1986), affd. without published opinion 829 F.2d 1119 (4th Cir. 1987).

In Byrd, the Commissioner asserted that expenses incurred by nurserymen in growing plants are normally deductible because the plants will be sold to customers in the ordinary course of business. However, since the plants in Byrd were distributed to shareholders in a corporate liquidation, this treatment was fundamentally inconsistent with the purpose behind the section 162 deduction. 87 T.C. at 836....