THE RECOGNITION, NON-RECOGNITION A;m RECAPTURE
. OF FARt1 AND RANCH TAX LOSSES
LEE GRIFFIN
CONTENTS
THE RECOGNITION, NON-RECOGNITION AND RECAPTURE OF
FARM AND RANCH TAX LOSSES
1
EARLY DEVELOPMENT
1
DEPRECIATION RECAPTURE AND LIVESTOCK
3
Section 1231 And The Holding Period For Livestock
5
Dual-Purpose Animals And The Holding , Period '
6
Like Kind Exchanges of Livestock
SECTION 1251 AND THE EXCESS DEDUCTIONS ,ACCOUNT .
10
12
Excess Deductions Account
13
Taxpayer Subject, to EDA Rules
14
Accrual Method Taxpayer Will Escape EDA
17,
Computation And Operation Of The EDA
18
Negative Balance In The EDA
" 20
Gifts And Effect On EDA
21
Corporate Reorganizations, Special Section
1251 Rules
24
Distributions And Partnerships, SpeCial Section
1251 Rules
•
26
Transfers at Death, Special Section 1251 Rules
29
Like-kind Exchanges And Involuntary Conversions,
Special Section 1251 Rules
29
Unfair Definitions And Section 1251
30
. RECAPTURING FARM LAND DEVELOPMENT EXPENDITURES
PROCEED~ ' PAID
HOBBY LOSSESI
TO CASH BASIS FARMERS FROM ' CROP INSURANCE
ACTIVITIES NOT ENGAGED IN FOR 'PROFIT
11
31
34
35
THE RECOGNITION, NON - RECOGNITION AND RECAPTURE
OF FARM AND RANCH TAX LOSSES
The farming industry has tax problems that are the
result of early administrative decisions that prescribed
different accounting principles for farming and nonfarrning
activities.
Subject to a few recent limitations, farmers
are allowed to expense costs which are capital expenditures
under usual accounting principles.
The origin of the farm and ranch loss and the related
problems that arise from the deduction of capital costs
while
allowin~
sales proceeds to be treated as capital gain,
will be briefly traced through its development. Thereafter
'.
Q.....
the areas of princip~ application shall be outlined with
some discussion and · demonstration of the benefits afforded
by the tax laws.
EARLY DEVELOPMENT
The treasury decisions which allowed farmers to expense
the 'cost of raising livestock, T·.D. 2153, 17 Treas. Dec.
Int. Rev. 101 (1915), as amended by T.D. 2665, 20 Treas. Dec.
Int. Rev. 45 (1918), and provided that the farmers could
report their income on either the cash or accrual method of
accounting, Treas. Reg. 33, art. 4 (1917), were the beginning
of the special treatment of the farm tax area.
The early regulations also concerned ' the development
of orchids and ranches, but contrary to the rule for
fJI ctM tfA ~
2
livestock, the early regulations required these costs to be
capitalized.
Treas. Regs. 45, art. 110 (1917).
Regs. ,33, art. ' 4 (1917).
Treas.
This inconsistency of allowing
livestock farmers an immediate writeoff while denying the
same advantage to other farmers incurring development costs
was resolved in 1 919.
Treas. Reg. 45, art. 110 (1919).
When farm expenses were formulated under these liberal
rules they had a great effect on tax liabilities.
Since
the deductions were premature, they created artificial tax
losses that would not have occurred if the expenses had
been capitalized.
When these artificial tax losses were
offset against income from other sources they created a
deferral of tax liabilities on that other income until the
farm assets were sold.
•
Capital Assets were first included in the Revenue Act
of 1921 but only to some extent, becaUSe depreciable
property used in the trade or business was excluded •
•
This was supposedly done so as to assure full deductibility
of losses.
This was corrected by Congress in 1942 and
capital gain treatment was extended to depreciable property
used in the trade or business.
Wells, Legislative History
of Treatment of Capital Gains Under the Federal Income Tax,
1913-1948, 2 Nat'l. Ta x J. 12, 31-32 (1949).
Since farmers considered their breeding herds to be
property used in the trade or business, they applied the
new rules to their own benefit.
This practice was fought
3
by the Commissioner of Internal Revenue until the controversy was settled in favor of the taxpayers in Albright v.
United States, 173 F.2d 339 (8th Cir. 1949).
This case
found that the culls from a dairy herd were property used
in the trade or business and that sales proceeds therefrom
qualified for capital gain treatment.
With this victory the livestocK interest.s lobbied and,
in the Revenue Act of 1951, moved Congress into enacting
. Section 324 which stated that livestocK held more than
12 months regardless of age and held for draft, breeding
or dairy. purposes would be treated as property used in
the trade or business.
This was the predecessor of the
Internal Revenue Code of 1954 §1231(b)(3) and provided ·
that an animal's basis for gain was to be determined under
the taxpayers' method of accounting.
In other words, in
order for the entire sales proceeds on an animal to be
capital gain because of a zero basis in the animal, the
,
taxpayer would have to be on a cash basis. Taxpayers who
capitalized or inventoried costs would use this basis and
have gain only to the extent proceeds exceeded the basis.
With this historical discussion attention can be
focused on the
~
princi~~e
application of farm and ranch
tax .law.
DEPRECIATION RECAPTURE AND LIVESTOCK
Section 1245 and the concept of depreciation recapture
4
was added to the 1954 Code by the Revenue Act of 1962.
Section 1245 ' (a) originally excluded livestock from its
provi sions.
I.R.C. §1245(a)(3).
Livestock is classified
as horses, cattle, hogs, sheep, goats, and mink and other
furbearing animals, irrespective of the use to which they
are put or the purpose for which they are held.
§1.1245-3(a)(4).
Reg.
The Commissioner' has also defined race-
horses as livestock.
Rev. Rul. 66-368 (C.B. 1966-2, 306).
This exclusion of livestock from Section 1245 was, corrected
by the Tax Reform Act of 1969, hereinafter referred to as
the TRA, and depreciation recapture now applies to all
livestock.
TRA S212(a)(2).
Since only draft, breeding, dairy, or sporting live-
•
stock qualify as depreciable property used in a trade or
business, I.R.C. §§167(a)(l), l23l(b)(3), and further,
since most farmers deduct the cost of raising livestock
under the cash receipts and disbucsements method of tax
accounting, Re g. Sl.47l-6(a), the recapture of livestock
depreciation as ordinary income should have little effect
on most farmers and ranchers.
Depreciation recapture
would apply only to livestock that has acquired a depreciable cost basis such a s pur chased livestock.
Therefore,
this change while having little effect on farmers and
'ranchers, would reduce the benefits to high-bracket taxpayers by investing in breeding herds.
5
Depreciation recapture under section 1245 will apply
only to that depreciation claimed in 1970 and after, and
t here
1970.
~i 1l
be no recapture of depreciation claimed before
I.R.C. §1245(a)(2)(c).
For example, if a breeding
animal was purchased in 1968 for $600 and was depreciated
$40 in 1968, $40 in 1969 and $40 in 1970 and sold on
January 1, 1971, for $550, the gain would be $70 ($550
less the adjusted basis of $480) and the recomputed basis
would be $520 ($480 adjusted basis plus $40 depreciation
after 1969).
This illustrates that the ordinary income
recapture would be $40 and the remaining $30 would be a
Section 1231 gain.
Section l23l , And The Holding Period .For Livestock
Before the TRA, taxpayers were generally allowed to
realize gain on all their Section 1245 livestock, except
those held for less than twelve mpnths, as capital gain
under Section l23l(b)(3).
Congress felt that the l2-months holding period for
cattle and horses was unsatisfactory for two reasonsl
(1) The farmer or rancher cannot immediately know which
new animals will be retained for breeding purposes and
which ones for sale in the ordinary course of business,
(2) a high bracket taxpayer who purchases a herd with the
intent of increasing its size by r ·etaining most of the
female calves for breeding purposes, currently deducting
6
operating costs under the cash method of accounting, could
then sell the herd at capital gain rates.
For these reasons, the TRA extend ed the Section 1231
h61ding pe r i o a f o r c at t le anchorses , rega rdl es s o f a g e ,
h el d for dra ft. breed ing. or d a iry pu r poses. to 2 4 months
or more.
All other livesto ck r e t a ined tho 1 . 1\\0nth holt1J.ng
period so as to not adversely effect other livestock farmers
such as hog farmers.
For example. a sow may have one or
two litters by the time she is 12 months old but after
that, the sow's feed requirements make it uneconomical for
the farmer to retain her as breeding stock.
Dual-Purpose Animals And The Holding Period
Just because an animal has satisfied the holding period
,
does not mean that it has been held for one of the specified purposes of breeding, dairy. or draft purposes rather
~12A4...J
than for sale to customers. An analyzation of I.R.C. i1231
(b)(3)(A)(B) would show that the specific purposes for
holding the livestock and the holding periods are two
separate. and unrelated requirements.
For example, if a
horse was held in inventory for one year and switched to
the breeding herd for another year, it would npt qualify
under the purpose test and the holding period requirement •
. Or, if a calf is held for one year but not committed to
the breeding herd for one year, the required holding period
would be extended to three years.
7
Another problem would seem to arise when 'an animal
is held for 24 months, but during that period is used for
two of the specific purposes.
An example of this would
be a dairy cow that is used first for breeding purposes
and then for dairy purposes.
Switching from one specified purpose to another
specified purpose should not prevent the gain on the animal
being recognized as long-term capital gain when the animal
is sold.
Denial of capital gain treatment in these situa-
tions would be straining the interpretation of Section 1231
(b) (3) (A), (B).
If the purpose and holding period requirements are read
as interrelated reqUirements, the statute does not appear
to require only one specified purpose.
The exclusion of
all other specified purposes in the 24 month holding period
would seem unfair when in practice alternate use of an
,animal is not an infrequent occurrence.
A race horse would
•
often be raced and bred in the same 24 month period.
It
certainly would not defeat the purpose of the statute to
permit more than one specified purpose within the required
' holding period.
The regulations already allow this to some extent but
in a ' different variation ,when animals that are culled from
a herd are considered.
Once the animal is held for 24,
months or longer, the important criteria is that it be
held for draft, dairy or breeding purposes when sold.
If
a
an animal is held for 24 months for breeding but before
it is actually used for breeding it is discovered to be
sterile or unfit for the herd, the regulations allow the
animal to still be considered for breeding purposes.
Therefore, the sales proceeds are still eligible for
capital gain treatment.
Reg. §1.1231-2(c)(1).
Replacement animals can be set aside at weaning and
deSignated for the breeding herd.
Then, as the animals
grow older, the unfit animals not meeting the herd
standards can be culled and still retain the Section 1231
classification.
This is supported by case law in the
area as is illustrated by Moore v. United States, 246 F.
Supp. 19 (ND Miss. 1965).
In this case the taxpayer
established a ' sale herd, replacement ~erd and a breeding
herd.
Heifers intended for the breeding herd were kept in
the replacement herd until maturity and bulls over 12
months of age from the replacement herd were eligible
•
for Section 1231 treatment.
I
'
Even though this case was
decided before the TRA, its effects will not be changed to
any great degree.
Naturally now that the holding period
has been extended to 24 months a bull held for 12 months
would not qualify for the Section 1231 treatment, but is
this all that could be considered from this case?
The
answer is no, many things can be gained from this case.
Many ranchers in this part of the country make it a
practice not to put their heifers with bulls in the first
9
season, because of the high risk of death in both the
heifer and calf crop.
Instead the common practice is to
wait until the cow's seco n d season before calving because
her greater maturity will facilitate her calf producing
capacity.
This practice was recognized in the Moore case
when the taxpayer was allowed to leave his heifers in the
replacement herd until they reached maturity.
Following this practice, every cow in the replacement
herd will meet the 24 month requirement because they will
not be calved until their second season.
The heifers
can be held until time for calving at which time some of
them will be culled and the others put into the breeding
herd and calved.
Since the heifers were held for 24
months, all of the culled cows will
q~alify
for 1231
treatment.
This practice cannot be flagrant and only a reasonable
number of animals should be placed in the replacement herd •
•
This would depend'on the rate at which mature animals were
culled from the mature breeding herd, and what the individual taxpayer's herd management practices were.
In
~
Beef Cattle Science Handbook, 96 (1961), it is recommended
'that up to 25 percent of the cow herd be culled per year.
In this range management expert's opinion, the culling rate
would require up to 50 percent of the heifer calves produced just to maintain the herd with such a culling percentage.
10
Following these guidelines if a rancher, for example,
h ad a 200' cow breeding herd, he would cull 50 cows every
year all of which
~~uld
be subject to 1231 treatment
they had been held for more than 24 months.
sinc~
This would
mean that the rancher would anticipate replacing the 50
culls with 50 cows in their second season from the replaceme nt herd so he could maintain . his herd strength.
Since
he is replacing 50 head of mature cows every year with
two year old cows from his replacement herd, it would only
be good practice for the rancher to put 75 heifer calves
in the replacement herd every year.
Then, in two years
when the time carne to put those heifers in the breeding
herd, .25 could be culled so as to maintain his herd
standards as high as possible.
•
.. The 50 mature cows from the breeding herd and the 25
two year old cows from the replacement herd would all be
culled·' at about the same time.
This would put the rancher
•
in the position of being able to go to market with 75 head
,
of cattle each year, all of which would qualify for Section
1231 treatment, and he has maintained his herd strength at
200 head.
Like Kind Exchanges Of Livestock
Before the TRA, taxpayers would exchange calves of
different sexes.
These exchanges were usually male calves
traded for female calves so as to build up breeding herds
11
faster.
It was possible to treat these exchanges as tax-
free because of Section 1031 (a) under which Reg. §1031
(a)-l(b) allows "the words 'like kind' to have reference
to the nature or character of the property and not to
its grade or quality."
In the case of Wylie v. United
States (D. Tex. 1968), the Texas court treated the transfers of 49 head of mixed cattle for registered AberdeenAngus cows as a tax- free exchange.
The Treasury disagreed with tax-free exchange for
livestock of different sexes but never publicly, as in
the form of a ruling.
The Internal Revenue Service was
particularly unhappy over the fact that apparently under
the tax-free exchange route, a sizeable breeding herd
•
could be quickly built up without tax consequences.
The
normal calf crop is divided approximately 50-50 between
male and female calves.
Few male animals need to be
retained for the normal breeding operation.
The male
calves which are castrated and sold as steers produce
ordinary income.
However, the tax on such income could
be avoided by swapping the male calves or steers for female
animals.
The female animals would be added to the breeding
herd which could be sold at capital gains rate.
Farm Losses Under The Tax Reform Act of 1969:
Davenport,
Keepin'
'Em
Happy Down o n the Farm, 12 ·B.C. Ind. & Com. L. Rev. 319,
329 (1971).
The TRA amended Section 1031 and that section now
12
provides " tbat " lj.yestocJ< , of d ,i fferent ._ s~xes . d~-:np~ ,q~?:.~H¥j"
as p r ope rty o f a lir.-e kind , I.R . C. §1 03 1 (e )
excha nges are taxable.
I
t h u s , such
Income gain, or loss is now
measured by the difference between the fair market value
of the animals received and the adjusted tax basis of the
l. i Vt1l:1tock oxchanged .
Since the cash method is normally
,used, the adjusted basis would be zero for raised live, stock.
The animals acquired would taJ<e an original cost
basis equal to the fair market value used in recording the
sale.
SECTION 1251 AND THE EXCESS DEDUCTIONS ACCOUNT
The TRA designed Section 1251 to halt abuses by taxpayers
currentl~
ded ucting farm losses against non-farm
•
ordinary income and later obtaining capital gain treatment
on the sale of the farm assets.
For example, before the TRA and Section 1251, a taxpayer using the cash method of accounting might have
incurred expenses of' $200,000 in raising a breeding herd.
When deducted, these expenses would have produced a tax
savings of $140,000 if the taxpayer was in the 70 percent
tax bracket.
When the herd was sold the entire sale
price, including the
recove~y
of the expenses of raising
the herd, would be taxed only at capital gains rates
because the herd would have a zero basis.
This is because
the cost and expenses of raising the herd had been entirely
deducted.
Assuming the taxpayer had sufficient income to
13
q ualify for the ·alternative tax und er Section 1201, prior
to amendment by the TRA , the resulting tax rate would have
been 25 percent, yielding a tax of $55,000, or less than
one-half of the $140,000 tax savings realized from the
deduction of the raising costs.
This would mean that even
though the taxpayer reali z e d an .economic profit of only
$ 20,000, h e would also have a net benefit from the government in the form of a reduction on taxes on other income
in the amount of $85,000.
It was because of these type conditions that Section
1251 was enacted.
It .should be noted at this time that
Section 1251 does not disallow any farm expenses, they
remain f ully deductible.
Section 1251 is in some respects
• provisions in
very Similar to the depreciation recapture
that its effect is to convert some farm capital gains to
ordina ry income.
Excess De ductions Account
Section 1251 operates through the Excess Deductions
Account, h e reinafter referred to as the EDA, an d cash
method farmers must establish and maintain an EDA.
s1251(b)(1).
I.R.C.
The EDA can only be avoided if the farmer
elects to use inventories and capitalize all expenditures
which are properly chargeable to capital accounts.
I.R.C.
§1251(b) (4).
Subject to certain dollar limitations, the EDA is
increased each year for the amount of the farm net loss,
14
I.R.C. s1251(b)(2), or decreased for the amount of the
farm net income for the year, I.R.C. s1251(b)(3)(A).
If
"farm - recapture property" is sold, -and there - is a balance
in the EDA at the end of the year, the gain that would
otherwise qualify as long-term capital gain under Section
1231 will be treated as ordinary income to the extent of
the balance in the EDA.
I.R.C. g125l(c).
The BDA balance
is then reduced by the amount recaptured as ordinary
income under Section 1251 but not below zerO.
I.R.C.
§1251(b)(3)(B), (c)(2)(A).
Taxpayer Subject To EDA Rules
All taxpayers who are cash method farmers are subject
to the BDA rules.
This includes individuals, partnerships,
corporations, estates, and trusts.
•
Before EDA is required of an individual farmer taxpayer certain dollar limitations must be met.
An individual has to have
~25,OOO
of net farm loss
for the year before he is subject to EDA and then he only
has to make additions to the EDA to the extent those
losses exceeded
~25,OOO.
I.R.C. s1251(b)(2)(B)(ii).
If
the taxpayer and his spouse file separate returns, the
minimum farm net loss floor is
~12,500
per return, unless
the taxpayer's spouse does not have any nonfarm adjusted
gross income for the year.
I.R.C. s1251(b)(2)(c).
Each individual taxpayer filing a joint return must
15
also have more than $50,000 of nonfarm adjusted gross
income before an EDA is required.
I.R.C. §125l(b)(2)(B)(i).
Nonfarm adjusted gross income means adjusted gross income,
I.R.C. 862, without taking into consideration the income
or deductions attributable to the business of farming,
LR.C. 81251 (b)(2)(D).
I f the taxpayer files separate
returns with his spouse, the minimum nonfarm income floor
is $25,000 per return, unless the taxpayer's spouse does
not have any nonfarm adjusted gross income for the year.
I.R.C. §125l(b)(2)(C).
Since these $50,000 and $25,000 limitations are contained in the EDA rules, most farmers will not be affected.
'These
limitat~ons
restrict the investment type farmer while
effectively exempting the dirt farmer from EDA recapture.
An effective way for farmers to reduce their EDA is
to carefully segregate their deductions that are otherwise
allowable from deductions related to the personal use of
,
farm property. An example of this would be to separate
deductions for taxes and interest from expenses incurred
in the operation of a farm house.
EDA rules also apply to farm partnerships.
Under the
conduit theory of Section 702, all items of partnership
income, deductions and credits, whether farm or nonfarm
:' .
items, retain their character in the hands of the partners.
Therefore, each partner in the farming operation will take
into account separately his share of farm net losses, farm
16
net income and ga ins from dispositions of farm recapture
property.
I.R.C. §1251(d)(5)(A).
The TRA allowed Subchapt er S corporations to be treated
as an individ ual for EDA purposes ~lhich would subject them
to the same $5 0,000 a nd $25 ,000 limitations at the co rpo ~
r a te l evel.
The inclusion of Subchapter S corporations
un der the EDA dollar limitations for individuals was a
~1.u:t
to tho t axpayer.
Many high - bracket individuals with
more tha n $5 0,000 of nonfa rm adjusted gross income and
f a rm n e t losses which exceed e d $ 25,000 -i ncorporated only
their farm operations,_ elected Subchapter S status, and
avoided any EDA balance at either the individual or
corporate level.
,
Th e Revenue Act of 1971 cured this de fect in the
Subchapter S corporation looph ole by amending Section 1251.
This section now adds the income of the highest income
shareholder to t h e Subchapter S corpo,ation's income to
det ermine whether the $5 0,000 limitation of nonfarm income
has been reached.
This section would also deny the $25,000
loss exclUSion in any case where a shareholder of a Subcha pter S corporation having a farm loss is also a shareholder of a second Subchapter S corporation having a farm
loss.
I.R ; C. !!l251(b) (2) ( B) .
0 ' Byrne, -Farm Income Tax
Manua l 69 (4th ed. 1970 Supp. 1971)
Trusts and corporations other than Subchapter S
corporations must add the full amount of their farm net
17
losses to the EDA.
any nonfarm income.
This applies even if they do not have
The EOA account is maintained at the
entity level.
This very strict application of the EOA rules without
dollar limitations to corporations is a 'very harsh rule.
With the hardship this will work on farm corporations, it
would seem wise for them to liquidate under Section 333
or perhaps consider a Subchapter Selection.
Accrual Method Taxpayer Will Escape EOA
If a taxpayer really wanted to avoid the requirement
of having to establish and maintain and EOA, he could do
so by electing to compute taxable income from farming (1)
by using inventories, and (2) by charging to ~ capital
•
account all expenditures which are properly chargeable to
a capital account.
I.R.C. s1251(b)(4)(A).
Although neither Section 1251 nor the 1251 Regulations
specify the items for which inventories must be used,
livestock inventories would certainly be included among
such items.
Reg. 81.471-6.
Expenditures properly chargeable to capital accounts
expressly include "expenditures which the taxpayer may,
under this chapter or regulations prescribed thereunder,
otherwise treat or elect to treat as expenditures which
are not chargeable to capital accounts."
(b)(4)(A).
I.R.C. 81251
It would appear, therefore, that such
18
expenditures would include soil and water conservation
expenditures under Section 175, fertilizer and soil conditioning costs under Section 180 and expenditures for
clearing land under Section 182.
When the election is made by a taxpayer to use
inventories and capitalize all · capital expenditures for
any taxable year, the request must be filed by the due
date of the return for the year to which the election
applies.
I.R.C. §1251(b)(4)(B).
The election is not
just for one year but for all subsequent years and may be
revoked only with the consent of the Commissioner.
1. R. C.
Bl25l(b) (4) (B).
Probably very few taxpayers will make the
e~ection
"to use inventories and capitalize all capital
expenditures,
•
because the cash method of accounting . for farmers still
permits significant deferral of income taxes, and nothing
is really gained by adopting the accrual method of
accounting.
Computation And Operation Of The EDA
This brings us to the operation of the EDA.
Section
1251 applies only if, and to the extent that there is
either a farm net loss for the year, or a balance in the
EDA account at the end of the taxable year.
To determine
if there was a balance in the EDA account at the end of
the year, farm net income would be offset against the
amount in the account.
19
For example, John Doe, a calendar year taxpayer,
consistently has non fa rm adjusted gross income of $ 75,000.
He owns an unincorporated farm that shows a farm net loss
of $40,000 in 1970.
In 1971, the farm has $5,000 of farm
net income, and, in addition, a bull, which has a zero
basis, is sold for $1,500 in a sale which qualifies for
long-term capital gain treatment under Section 1231.
1972, the farm has a farm net loss of $3,500 .
In
In 1973,
his ordinary farm income just equals farm expense, but he
sells . breeding livestock which he held more than two
years,· valued at $12,500 but without any basis.
John Doe's EDA and recapture are computed as follows.
EDA
Year
1 9 70
1 9 71
1972
1973
Additions
$15,000
-0-0-0-
Subtractions
$ -06,500
-08,500
In 1970, the taxpayer enters
$~5,OOO
Balance
$15,000
8,500
· 8,500
-0in the excess
deductions account (the excess of the $40,000 loss over
the $25,000 limitation).
In 1971, the EDA is reduced for the farm net income
of $ 5,000 plus the $1,500 gain (Section 1251 recapture)
on the sale of the bull (farm recapture property), since
the EDA is larger ($10,000) than the gain.
In 1972, the loss does not add to the account .because
the loss is less than $25 ,000.
at $8 ,500.
Thus, the account remains
20
In 1973, when
, the -livestock is sold it reduces the
BDA of the full $8,500 balance in the account because the
$12,500 was gain on the sale of Section 1231 livestock.
The gain is treated as ordinary income from Section 1251
recapture to the extent of the $8,500 EDA.
The balance
of the gain, $4,000, would be treated as long-term capital
gain.
Negative Balance In The EDA
It is clear that when there is a balance in the EDA
it will be reduced by any farm net income in subsequent
years.
Thus, if a taxpayer is fortunate enough to have
his good years subsequent to his bad ones the profit years
will offset the loss years in determining his EDA.
the contrary does not appear to be true.,
But
Since there is
no negative EDA, if a taxpayer's profit years precede his
loss years, the profit years do not reduce the amount in
his EDA.
As unfair as this is, it appears to have been
,
intentional. Section 1251(a) provides I
This section shall apply with respect to any taxable
year only if-(i) there is a farm net loss for the taxable year, or
(ii) there is a balance in the excess deductions
account as of the close of taxable year • • • I.R.C.
125l(a)
In addition, Section 1251(b)(3) provides that a subtraction
from EDA for any farm net income is made only if there is
an amount in the account at the end of the taxable year.
21
. Thus, if a taxpaye r with nonfarm adjusted gross income
in exce S s of $50,000 had a farm net loss of $100,000 in
1970 and farm net profit of $50,000 in 1971, his EDA at
the end of 1971 would be $25,000 computed as follows.
1970 Farm Net Loss
$25,000 Limitation
Balance in BDA--1970
1971 Farm Net Income
Balance in EDA--197l
$100,000
($ 25,000)
$ 75,000
($ 50,000)
$ 25,000
However, if he had produced his $50,000 farm net income in
1970, and had incurred his farm net loss of $100,000 in
1971, his EDA would be $75,000, calculated as follows.
$ 50,000
1970 Farm Net Income
Balance in EDA-~1970
1971 Farm Net Loss
$25,000 Limitation
Balance in EDA--197l
o
$100,000
$ 25,000
$ 75,000
It is submitted that this result
~s
unfair and that
legislation should be enacted providing for a negative EDA
so that the balance in the account is not affected by the
timing of income or loss years.
Until such legislation,
,
attorneys who' counsel clients engaged in farming activities
might make it very clear to them that if income and loss
years cannot be timed to keep the EDA as low as possible,
the results could be disastrous.
Gifts And Effect On EDA
EDA is not recaptured in a gift ' of farm recapture
property.
loR.C. 1l12 5 1( d ) (1).
Ho we v er , i t in " ny o n$!
22
properties which carry at least 25 percent of his total
potential gain ort farm recapture property held by the
donor immediately prior to the first of such gifts, then
a pro-rata part of the excess deductions account shall be
transferre d to the donee of such farm recapture property.
The donee succeeds to a portion of the donor's EDA
at the time of the first gift, but the EDA is computed as
of the end of the donor's taxable year in which the first
gift is made.
I . R.C. §1251(b)(5)(B).
The portion of the
donor's EDA to which the donee succeeds is the ratio of
(1) the potential gain on the gift property and (2) the
total potential gain on all farm recapture property held
by the donor immediately prior to the first gift, to the
,
donor's EDA at the end of the year.
,Potential gain is the amount by which the fair market
value of any farm recapture property exceeds its adjusted
basis.
I.R .C. §1251(e)(5).
In the case of land, in order
to preserve the special rules relating to the recapture
of only the Section 175 and 182 deductions on land,
potential gain includes only those deductions which have
been taken in the current taxable year and the preceding
four taxable years.
loR.C. ID.251(e) (5).
The potential
gain limitation on farm land is significant because it may
permit capital gain on sale of the land even though the
taxpayer may have a large EDA.
- recapture may apply to the sale.
However, Section 1252
23
For example.
On June 1, 1971, the donor holds farm
recapture property '(other than land) worth $60,000, with
an adjusted b a sis of $40,000.
On the same date, he makes
a gift of such property worth $20,000, with an adjusted
basis of $10,000.
is $12,000.
The donor's EDA at December 31, 1971,
S ince the gift represents more than 25 percent
of the donor's potential gain for all farm recapture property, the donee takes $6,000 of the donor's EDA, computed
as follows.
$10,000 X $12,000 = $6,000
$20,000
Thus, gifts offer a means for tax planning.
By
making "25 percent or less" gifts, the donor can shift
farm recapture property to family members without any EDA
,
,
stigma. Hjorth, Farm Losses and Related Provisions, 25
Tax L. Rev. 581, 599 {1970}.
periodic gifts of undivided
Hancock, 19 T.C.M. 1293.
The courts have approved
intere ~ ts
in property.
S.F.
Alternatively, the donor can
shift EDA balances to a low-bracket family member by
making "more than 25 percent" gifts of farm recapture
property.
Section 1251 recapture of the EDA balances which
are succeeded to cannot be avoided by the donee adopting
an accrual method of accounting.
I.R.C. g1251{b}{4}.
Farm recapture property retains its character in the
hands of a donee or transferee who has or could succeed
to the EDA of the donor or transferor, regardless of the
use to which the donee or transferee places the property.
· 24
I.R.C. §l251(e)(1)(A), (b)(5).
Corporate Reorganizations, Special Section
1251 Rules
Where the acquiring corpor",.tion in a corporate
reorganization inherits the transferring corporation's
tax attributes under Section 381, it will also inherit
the transferring corporation's EDA.
I.R.C. sl25l(b)(5)(A).
However, it appears that although the farm recapture
property retains its character as such in the hands of
the corporation, 'the corporation does not succeed to the
transferor's EDA in nonrecognition transfers of farm
recapture property to controlled corporations under
. Section 351.
In a Section 351 exchange the transferor
retains the EDA, and the stock or secu][·ities acquired
become farm recapture property to the extent attributable
to the fair market value of farm recapture property contributed to the corporation by the transferor. I.R.C •
•
s1251(d)(6). Hjorth, Farm Losses and Related Provisions,
2!? · Tax L. Rev. · 581, 599 (1970).
For example, John Doe transfers a breeding herd to
the Cummins Corporation in exchange for 1,000 shares of
stock in the corporation.
The transaction qualifies under
Section 351.
a
The herd has
fair market value at the time
Of . the exchange of $30,000 with an adjusted basis of
$19,000.
The stock received by John Doe will be treated
as farm recapture property to the extent of $30,000.
25
Assuming that John Doe had an EDA account of at least
$11,000, the potential gain subject to Section 1251
recapture should not exceed $11,000 ($30,000- $19,000)
even if the value of his stock goes to $35,000 or more.
On the other hand. if the value of the stock decreases
below $30,000, the amount of recapture should decrease
accordingly.
The fact that the farm recapture property retains
its character in the hands of the Cummins Corporation
could lead to unexpected results.
The Cummin's basis
might be very low in the acquire d property, and even
though it does not inherit John Doe's EDA its own account
could grow qUite rapidly because it is not eligible for
either the exemption or the annual $25,000 exclusion.
,
In
the example, it is assumed that the Cummin's Corporation
. is not a qualified Subchapter S corporation.
Corporations
such as this that have failed to qualify under SubchapterS
or which have lost their SubchapterS status would work
under a great tax hardship.
Corporate transfers in liquidation take a carryover
basis under Section 332.
When the liquidation falls under
Section 332, the transferor will be treated as having
ordinary income only if gain is recognized apart from
Section 1251, and then only to the extent of the lower of
the recognized gain or the EDA balance,
26
The rules for reorganization are similar to those for
liquidations under Section 332.
Ordinary income is imputed
only to the extent of the lower of gain recognized apart
from Section 1251 or the balance in the transferor's EDA.
Reorganizations that fall under Section ' 38l will result in
a carryover of the transferor's EDA to the transferee.
The
consequence is that in corporate reorganizations where
nearly all the property is transferred, the EDA balance
carries over to the transferee.
The acquiring corporation
cannot escape Section 1251 recapture as to the farm recapture property by adopting an accrual method of accounting.
I.R.C. 6l25l(b)(4).
Distributions And Partnerships, Special
Section 1251 Rules
Partnerships raise three problems with respect to
farm recapture property (1) disposal of such property by
the partnership, (2) distribution of such property by the
partnership to partners, (3) contribution of farm recapture
property to the partnership by a partner.
Under the first problem, under Section 1251 each
partner takes into account separately his distributive
,share of the farm net losses and gains from the disposition
of farm recapture property.
Thus, the partnership is a
conduit for the purpose of adding farm losses to BDA,
reducing the balance in an EDA by the amount of farm income
for the year and for realizing gains on the disposition of
27
farm recapture property.
The second problem of distributions from partnerships
are not dealt with directly in the Code, but Section 751,
which defines unrealized receivables, has been amended to
include farm recapture property and farm land subject to
recapture of Section 175 and 182 deductions.
I.R.C. 751(c).
Where a partner transfers farm recapture property to
a partnership, the third problem, Section 1251 provides
,.that he is to recognize gain only to the extent that the
value of the farm recapture property transferred by him
exceeds the value of his partnership interest which is
attributable to that property.
I.R.C. 1251(d)(5)(B).
For example, John Doe transferred cattle (farm
recapture property) having a $1,000 value but a zero
,
basis to a partnership in which Dave Cummins transferred
cash of $1,000 to be an equal partner.
The value of
John Doe's interest would be $1,000, and this value
apparently would be attributed $500
$500 to cash.
t~
the cattle and
Doe then would realize $500 of ordinary
income on the contribution because the fair market value_
of the farm recapture property transferred was $1,000 and
exceeded by $500 the value of Cummin's interest in the
partnership which is attributable to the cattle.
The
cattle would have a zero basis to the partnership, and if
it sold them for $1,000, the partnership would realize
$1;000 of gain.
Half of this gain would pass through to
28
John Doe as gain on farm recapture property since he
accounts for these items separately.
Assuming he had a
balance in his EDA, this gain would be treated as ordinary
income.
When this $500 gain is added to the $500· gain
realized at the time of contribution, John Doe will have
realized $1,000 of ordinary income with respect to the
cattle.
This is a proper result because the amount is
equal to what John Doe would have reaiized had he sold the
cattle and contributed cash.
EDA recapture could have been avoided in the example
if the partnership agreement had provided that all gain
on the. farm recapture property would be allocated to the
partner who contributed such property.
I.R.C. §1251(d) (5) (B).
Thus, in our example, if the . partnership
, agreement allocated
the entire gain on the cattle to John Doe, the entire value
of his partnership interest would have been attributable to
the cattle.
Since that value and the value of the cattle
were equal, he wou ld have no ordinary income on the contribution.
When the cattle were sold by the partnership, the
entire gain of $1,000 would be allocated to Doe in
accordance with the partnership agreement, and he would
realize the entire gain as ordinary income, assuming he had
a balance in his EDA.
The purpose of this provision is clear.
It requires
ordinary income to be recaptured at the time of contribution
unless the transferring partner agrees to take the gain on
29
the transferred farm recapture property into account when
disposed of by the partnership.
In short, if the trans-
ferring partner agrees to have the gain on the assets
contributed by him allocated to him and taxed to him as
ordinary income if and when disposed of by the partnership, then there is no gain on the transfer to the partnership.
If the partnership agreement does not so provide,
the appa rent intent was that the contribution itself be a
disposition requiring recognition of ordinary income.
Transfers at Death, Special Section 1251 Rules
Death, however inadvisable, is one means a farmer
might use to escape EDA.
Except to the extent that income
in respect to a decedent is realized upon a transfer at
death, there is no realization of ordinary income upon the
transfer by decedent to his estate.
no transfer of EDA either.
Apparently, there is
I.R.C. §§1251(d)(2), 691(a)(3).
Like-kind Exchanges And Involuntary Conversions,
•
Special Section 1251 Rules
In such transactions, Section 1251 recapture is not
to exceed (1) the amount of gain recognized under Section
1031 or 1033, plus (2) the fair market value of qualified
property which is not farm recapture property.
s1251(d)(4).
I.R.C.
The purpose of this rule is to prevent a
taxpayer with a substantial EDA from exchanging his farm
. recapture property for other property to be held for
productive use of investment.
The Section 1251 recapture
30
would apparently prevent any qualified, nonfarm property
received from having a carryover basis; thus, the property
received would not become farm recapture property.
§1251(e)(1)(B).
I.R.C.
For example, suppose John Doe exchanges
Some farm land for an office buildi ng.
"exchange under Section 1031.
farm recapture property.
This is a tax free
The office build ing is not
Thus, if John Doe had a balance
in his EDA , he would recognize ordinary income in the lower
,of (a) gain realized, (b) the amount in his EDA, (c) the
fair market value of the office building.
Unfair Definitions And Section 1251
Section 1251(e)(2), (3) defines farm net loss and
farm net income so as to include all gross income derived
,
from the trade or business of farming, except that gains
and losses from the disposition of farm recapture property
are not taken into account.
I.R.C. §1251(e)(2), (3).
The exclusion of Section 1231(a) gains and losses is
necessary to accomplish the recapture purpose of Section
1251, namely, the recapture of ordinary deductions on the
sale of capital gain assets.
This definition of net farm loss has some harmful
consequences.
For example, depreciation is first recaptured
under Section 1245(a).
But depreciation recapture income
does not reduce the taxpayer's EDA.
(e)(2).
I.R.C. §1251(b)(3)(A),
The farm net income which reduces the EDA is
computed without taking into account Section 1231(a) gains
31
or losses.
Therefore, Section 1251 can result in the double
recapture of depreciation; first, under Section l245(1l)
and, second, under Section 1251 if the depreciation deductions, by reason of farm net losses, have been added to
the EDA.
It would seem that Congress should amend
Section 1251 to permit the EDA balance to be reduced for
depreciation amounts taken on farm recapture property and
recaptured under Section l245(a).
RECAPTURING FARM LAND DEVELOPMENT
EXPENDITURES
Before the TRA some high-bracket taxpayers had
achieved tax avoidance through short-term investments in
farm land by electing to deduct such, expenditures and
then obtaining capital gain treatment on sale of the
reconditioned farm land.
Section 1252 recapture applies to farm land which has
been held by a taxpayer for less than ten years for which
deductions have been allowed under Sections 175 and 182.
I.R.C. §l252(1),(2).
Section 175 relates to soil and water
conservation expenditures, and Section 182 relates to land
clearing expenditures which represent capital expenditures
otherwise deductible by election.
Presumably the manner
in which the section reads permits such deductions to be
allocated to specific parcels of farm land if proper
records are maintained by the taxpayer.
Griffith and Joy,
33
there is no farm loss it will still apply, and because it
applies to Sections 175 and 182 deductions incurred more
than five years before disposition.
There will be those
cases, however, where Section 1251 will be applicable
when Section 1252 is not.
An example of this would be
when the land has been owned ten years but the deductions
are incurred within four years of disposition and there
is a balance in EDA.
To The Farmer'
Griffith and JOY, What The Act Does
Farm Parity Or Class Discrimination? 23
Tax Lawyer 495, 504 (1970).
For example, John Doe, who is on a calendar year
basis, acquires a farm on January 1, 1971.
farm December 31, 1978, for a
December 31, 1978', is
~40,000
~15,000.
gain.
He sells the
His EDA at
During 1971-1973, Doe
"
spent and deducted
~20,000
for soil and water conservation
and land clearing expenditures··.
deducted another
~10,000
John Doe also spent and
of such costs in the period
1974-1978.
The
~10,000
in expenditures deducted during 1978 and
the four preceding years (1974-1977), is subject to
recapture by Section 1251.
The Section 1252 recapture would be computed as.. follows '.
Section 1252 recapture within the
8th year of acquisition
(40% X ~30,000)
Less, Section 1251 recapture
Limit on Section 1252 recapture
$12,000
10,000
$ 2,000
34
The balance of gain totaling $28,000 would be treated as
Section 1231 long-term capital gain.
To illustrate I
Section 1251 recapture
Section 1252 recapture
Section 1231 gain
Total gain
$10,000
2,000
28,000
$40,000
PROCEEDS PAID TO CASH BASIS FARMERS
FROM CROP INSURANCE
Before the TRA a farmer whose crops had been destroyed
and who received crop insurance proceeds to compensate him
for his loss was required to report the proceeds in the
year in which they were received due to his cash basis.
The result was that there was normally a doubling of
income in one year since the proceeds from the sale of the
previous year's crops was typically realized in the
following year.
For example, if John Doe's $30,000 wheat crop was
destroyed by hail in 1968, he would have had to report
about $60,000 dollars of income for 1968 because he would
•
. alsobe realizing the $30,000 dollars he made on his
previous year's crop.
It would follow that since Doe's
crop was destroyed in 1968, he would realize no income in
1969 since the crop insurance proceeds on the 1968 crop .
were realized in that year.
To illustrate I
35
1967
Income from the 1966 wheat crop
1968
Income from the 1967 wheat crop
Crop insurance proceeds on the
destroyed 1968 wheat crop
Total 1968 income
1969
No income 1968 crop destroyed
1970
Income from the 1969 wheat crop
Income *
$30,000*
$30,000
30,000
$60,000
-0$30,000
*It is assumed that John Doe's wheat crop yielded
$30,000 annually.
To eliminate this hardship resulting from bunched
income due to the receipt of crop insurance proceeds,
Section 451(d) was added to the Code.
Section 451(d)
provides that a cash basis taxpayer-farmer may elect to
inclUde crop insurance proceeds in income for the taxable
. year . following the taxable year of destruction or damage,
provided that he establishes that, under his normal
practice, income from the damaged crops would have been
reported in the following year.
Thus, John Doe will be
able to . maintain his yearly income i.f he ever has another
crop destroyed and receives crop insurance proceeds.
HOBBY LOSSES. ACTIVITIES NOT ENGAGED
IN FOR PROFIT
A busy executive in a city may operate a ranch or
farm as a part time matter because he enjoys it.
This
does not .mean, however, that he will be able to deduct
his incurred expenses even though he hopes to make a
profit either before or after taxes.
Farming expenses
cannot be deducted unless the taxpayer intends to operate
36
his f arm as a bona fide trade or business and not merely
for h i s personal pleasure or convenien·ce.
Since judgment
of motive is very difficult, taxpayers have been rema rkably successful in sustaining farm expense deductions even
under questionable circumstances.
In Commissioner v.
Widener, 33 F.2d 833 (3rd Cir. 1929), the taxpayer was
allowed more than $300,000 in four years, and in John S.
El lsworth, 21 T.C.M. 145 (1962), the taxpayer was allowed
his losses of almost $700,000 in 13 years on a breeding
operation appropriately named "Folly Farm."
The repealed Section 270 controlled hobby losses
before the TRA.
This section provided that where deduc-
tions by an individual taxpayer from a trade or business
exceeded income from such operations by more than $50,000
per year for each of five consecutive Years, the taxpayer's
tax could be recomputed by limiting deductions to $50,000
in excess of income for each of those five years.
Section
270 was ineffective not only because of the large deduc•
tions avail able in any event, but also because a taxpayer
could avoid it completely by reducing his net loss to less
than $50,000 every fifth year.
The TRA repealed Section 270 and added Section 183 to
the Code, which applies to individuals and Subchapter S
corporations.
Under Section 183 deductions for activities.
not engaged in for profit are limited as follows.
(1) A
deduction will be allowed for deductions permitted by the
37
Code without regard to whether they were incurred in
connection with a profit making activity.
(b)(l).
I.R.C. §lB3
(2) To the extent that gross income exceeds the
deductions allowed under paragraph one, the individual
can deduct other items which would be deductible if the
activity had been engaged in for profit.
I.R.C. elB3(b)(2).
For example, if John Doe has $50,000 of gross income
from an activity not engaged in for profit, $20,000 of
deductions otherwise allowable (taxes, interest, etc.),
and $ 50,000 of operating expenses, he will be able under
Section 183(b)(1) to deduct the $20,000 of taxes, interest,
etc. and be limited by Section 183(b)(2) to $30,000 of
operating expenses.
If there is doubt about the
profi~-seeking
the taxpayer is aided by a presumption.
motives,
If in any two or
more taxable years in a period of five consecutive years
the gross income from the activity exceeds the deductions
•
attributable to such activity, then unless the Commissioner
can show to the contrary, there is a presumption of profit
seeking.
I.R.C. §lB3(d).
For businesses consisting of
breeding, training, showing or racing of horses, the fiveyear period is extended to seven years.
I.R.C. §183(d).
Even if a taxpayer is suffering an unusual number of
tax losses every year, it would still seem easy to avoid
the consequences of Section lB3.
To meet the presumption
of profit seeking requirements thereby avoiding Section
38
183, the taxpayer would only have to show net income in
40 percent of his years.
Since the cash method of
accounting is permitted for farm income and expenses, the
taxpayer can defer either the expenses or the income of
one year to a later year and get a doubling-up effect.
If
this method was not sufficient to show a profit, the taxpayer could anticipate expenses or income from future
years.
If necessary, he can combine "into a single year
the d eferred income of prior years, the current income,
and anticipated future income while d eferring all current
expenses.
Thus, it is nearly inconceivable that a farmer
using the cash method of accounting cannot show at least
one dollar profit in some two out of five consecutive
taxable years. , Could it be that the new Section 183 is
almost completely ineffective?
LEE GRIFFIN
~54
TABLE OF AUTHORITIES CONSULTED
Cases
Albright v. United States, 173 F.2d 339 (8th Cir. 1949)
Commissioner v. \Videner, 33 F.2d 833 (3rd Cir. 1929)
John S. Ellsworth, 21 T.C.~l. 1~.5 (1962)
Moore v. United States, 246 F.Supp .• 19 (N.D. Miss. 1965)
s.
F. Hancock, 19 T.C.M. 1293 (1960j
St'l.tutes
Internal Revenue Code of 1954 (1971)
Income Tax Reguiations {1971 j
Legal Periodicals
Allington, Farminp; As a 'rax Shelter, 14 So. D. L. Rev.
181 (1969)
•
Davenport, Farm. Losses Under The Tax Reform Act Of 1969:
Keepin t t Em Hapny Down On The Farm, 12 B. C. Ind. &.
Com. L. RI'lv. 319 (1971)
Davenport. A Bountiful Tax Harvest, 48 Tex. L. Rev. 1 (1969)
Griffith and Joy, i'That The Aet Does To The Farmer: Farm
Parity Or Class DiscriJ11ination? 23 Tax Lawyer 495 ( 1970)
. Hawkl.nsrln, Farm Bxpenses And General Accountinp; Principles,
.
22 Tax L. Rev. 2 37 (1967 1
ltjorth. Cattle Con · ress And The Code-The Dan ers Of 'fax
Incentives, Wise. L. Rev.
1 19
Hjorth, Farm Losses And Related Provisions, 25 Tax L.
~ 5B1 i1970)
Keast, Tax Aspects Of TJivestock Ope r at ion s , 33 1-10. L.
Rev . hoo 11 ';/68 I
!-listor Of 'rreatment Of Co. i tal Gains
Income Tax 191 -1 9 ,2 Nat'l.
Comments , Cattle And Taxes Un der The 1969 Tax Reform Act,
17 U.C. L.A. L. Rev. 1251 (1970)
TextsCommerce Cle a r i n g House, 1970 Federal Tax Course (1969)
H. Halst.ead, Feder al Inc ome Taxation Of Far mers (1961)
Kyrl,
Deef Cattle Science Handbook 96 (1 961 )
J. O' Byrne, Farm Income Tax Manual (4th ed. 1970 SUDD . 1971)
Simonett i and Garian, Ana l ysis Of The Tax Reform Act
Oli i 969 (i 9 Ii)
.
Summa , Wo r king l1i th The Revenue Code-1971 (1971)