Decisions — Seeds of success

Image source: Huntington and Page; Huntington, J. T; Page, T. V; Henry G. Gilbert Nursery and Seed Trade Catalog Collection [No restrictions], via Wikimedia Commons

From small seeds come tax deductions for farmers. And though you may not be able to count the number of apples in a seed, like every other taxpayer, the number of times farmers can take a deduction for a seed purchase is once.

In 147 T.C. No. 17 (Backemeyer), the question was whether the taxpayer benefited from a double deduction of seeds and other items purchased for a farm. If so, under the tax benefit rule, the taxpayer would have to recapture deductions taken on a prior return.

The taxpayer’s husband was a cash basis sole proprietor farmer. He purchased seeds and other items necessary for his farm in 2010, with the intention of using them when he planted crops in 2011. The taxpayer and her husband filed a joint return for tax year 2010 and claimed a deduction of $235,693 for the purchases.

The taxpayer’s husband died in 2011, before he had the opportunity to use the seeds and other items. After his death, the seeds and other items were included in the assets of his estate, and passed to a family trust.

In 2011, the taxpayer took an in-kind contribution of the seeds and other items from the trust, and used them all to grow crops. She sold a portion of the crops in 2011, and the remainder in 2012.

She filed a joint return with her deceased husband for tax year 2011, and claimed a deduction for the same $235,693 of farm expenses that her husband had claimed the year before.

The IRS said the taxpayer’s husband was correct to deduct the items on the joint 2010 return, and the taxpayer was correct to deduct the assets she inherited from her husband on the joint 2011 return.

However, the IRS says the tax benefit rule requires that since the expenses had already been deducted in 2010, those expenses would also have to be included in 2011 income (effectively resulting in no deduction). Otherwise, the taxpayer would benefit from the same deduction twice.

The IRS says the tax benefit rule requires a taxpayer to include a previously deducted amount in the current year’s income when an event occurs that is fundamentally inconsistent with the claimed deduction for the previous year.

That event occurred in 2011, according to the IRS. When the taxpayer’s husband died, the seeds and other items had not been used, and were transferred to the family trust. The transfer converted the items from business use to personal use. When the taxpayer received the items from the trust, she contributed them to her farming business. That converted the items back from personal use to business use.

The IRS says the conversion from business asset to personal asset and back again meets the “fundamentally inconsistent event” requirement. While the IRS agrees the taxpayer can deduct the items, the IRS argues she must also recapture the prior year deduction because of the conversion.

The taxpayer says she inherited the items, which gives her a “fresh start” and allows an income tax deduction. She says the items were taxed under the estate tax rules, and to deny the deduction on her income tax return would subject the items to double taxation (estate and income).

The tax court says a four-part test determines whether the tax benefit rule applies to a particular situation.

(1) The amount was deducted in a year prior to the current year,

(2) the deduction resulted in a tax benefit,

(3) an event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and

(4) a nonrecognition provision of the internal revenue code does not prevent the inclusion in gross income.

The court says the first two criterion are met, and the case will be decided on the answers to the last two.

 

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

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Right answer!
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For the Taxpayer.

We use a four-part test to determine whether the tax benefit rule applies to a particular situation.

An amount must be included in gross income in the current year if, and to the extent that

(1) The amount was deducted in a year prior to the current year,

(2) the deduction resulted in a tax benefit,

(3) an event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and

(4) a nonrecognition provision of the internal revenue code does not prevent the inclusion in gross income.

The first two criteria are met in this case: The taxpayers did deduct the farm input expenses for a prior year, and that deduction reduced their taxable income, thereby affording them a tax benefit. However, the third and the fourth criteria are not met.

As to the third criterion, neither the death of the taxpayer’s husband nor the distribution of the farm inputs to, and their use by, the taxpayer was fundamentally inconsistent with the premises on which the initial section 162 deduction for tax year 2010 was based.

There is a line between merely unexpected events and inconsistent events. Death is the quintessential “merely unexpected event.”

Having established the inapplicability of the third criterion in this case, we now turn to the fourth criterion, which mandates that a nonrecognition provision of the code not prevent the inclusion of the tax benefit in gross income.

This requirement is not met here, since nonrecognition on death is among the strongest principles inherent in the income tax.

In view of the above, we find that the tax benefit rule does not apply to recapture for 2011 the deductions for farm input purchases made in 2010.

We find the IRS’s denial of the deductions improper.

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