Change in Treatment of Leased Farmland Was an Improper Accounting Method Change

(Parker Tax Publishing April 2023)

The Tax Court held that a corporation that owned and leased farmland to tenant farmers failed to secure IRS consent under Code Sec. 446(e) and therefore was precluded from implementing an accounting method change with respect to base acres rented to tenant farmers. The court also found that the taxpayer was required to include in income a positive Code Sec. 481 adjustments for Code Sec. 197 amortization deductions with respect to the base acres. Conmac Investments, Inc. v. Comm'r, T.C. Memo. 2023-40.

Background

Conmac Investments, Inc. (Conmac) is an Arkansas corporation that owns and leases farmland to tenant farmers. In 2017, the IRS determined that Conmac had deficiencies for 2013 and 2014 as a result of adjustments with respect to an unauthorized accounting method change by Conmac for amortization of "base acres" rented to tenant farmers. Created by Congress, "base acres," also known as acreage base or crop contracts, are the right to receive farm program subsidies for the production of certain commodities, such as wheat, cotton, or rice, from the U.S. Department of Agriculture (USDA).

Conmac acquired and placed in service farmland that included base acres in years between 2004 and 2013. Conmac did not farm any of these base acres during the years at issue. Instead, all of the base acres, if farmed, were farmed by tenant farmers. In addition, all base acre payments, if made, were paid to and collected by tenant farmers. None of the lease agreements between Conmac and the tenant farmers were evidenced by writing. The annual rental rate for the oral lease agreements was generally 25 percent of the gross income received by the tenant farmers from their farming activities. Under these agreements, the gross income of the tenant farmers included the farm subsidy payments that they received on account of the base acres the farmers rented from Conmac.

Before 2009, Conmac did not claim any deductions for amortization or depreciation of base acres rented to tenant farmers. Beginning in 2009, however, Conmac began claiming an amortization or depreciation deduction for base acres acquired and placed in service in 2004 continuing through 2013. Conmac did not attach Form 3115, Application for Change in Accounting Method, to its Form 1120 for 2009 or otherwise seek or obtain the IRS's consent to change its accounting method with respect to the rented-out farmland in 2009 or thereafter. Neither did Conmac file amended returns with an explanatory statement for all open years reclassifying the base acres rented to tenant farmers as amortizable Code Sec. 197 intangibles. Nor did it adopt the same accounting treatment for all base acres that it owned.

The IRS determined that Conmac's new accounting treatment for amortization or depreciation of base acres rented to tenant farmers was not a permissible accounting method and increased Conmac's income accordingly. Conmac challenged the notice in the Tax Court.

Code Sec. 446(a) requires a taxpayer to compute taxable income "under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." Under Reg. Sec. 1.446-1(e)(1), a taxpayer generally may adopt any permissible method. Reg. Sec. 1.446-1(e)(2)(ii) provides that an accounting method consists of both the overall plan of accounting for gross income or deductions and the treatment of any material item used in such overall plan. An item is "material" if it involves the proper time for the inclusion of the item in income or the taking of a deduction.

Under Code Sec. 446(e), once an accounting method has been adopted, it generally may not be changed without the IRS's consent. Reg. Sec. 1.446-1(e)(2)(ii)(d)(2) provides that a change in the treatment of an asset from nondepreciable or nonamortizable to depreciable or amortizable, or vice versa, is a change in method of accounting. Reg. Sec. 1.446-1(e)(2)(ii)(b) states that a change in the method of accounting does not include a change in treatment resulting from a change in underlying facts.

Under Reg. Sec. 1.446-1(e)(2)(ii)(d)(5)(iii), when the IRS changes the treatment of an asset from nondepreciable or nonamortizable to depreciable or amortizable (or vice versa), the change results in a Code Sec. 481 adjustment. Code Sec. 481 adjustments prevent the duplication or omission of income or deductions when a change in method occurs. Such adjustments reflect the cumulative difference between the new and the old methods.

Conmac argued that its change in tax reporting was based on a change in underlying facts and therefore was not a change of accounting method. Conmac also contended that even if it was required to obtain IRS, the lack of consent was irrelevant because it related to a closed tax year. In Comm'r v. Brookshire Bros. Holding, Inc., 320 F.3d 507 (5th Cir. 2003), aff'g T.C. Memo. 2001-150, the Fifth Circuit held that the IRS's challenge to a method change for which consent was never given must be for the year of the improper change, and that the failure to obtain prior consent under Code Sec. 446(e) does not serve as a basis to challenge such a change for a closed year. Conmac further argued that, even if a Code Sec. 481 adjustment was permissible, it needed to have been made for the "year of the change," which Conmac defined to be 2009. Because that year was closed by the statute of limitations on assessment, Conmac maintained that no Code Sec. 481 adjustment should be allowed.

Analysis

The Tax Court held that Conmac's change in treatment of amortization or depreciation of base acres rented to tenant farmers was a change in method accounting which was impermissible because Conmac violated the Code Sec. 446(e) consent requirement. The court also held that the IRS properly made a Code Sec. 481 adjustment relating to Conmac's unauthorized method change in 2009 in order to prevent the omission of income.

The court found that Conmac made a "business decision" in 2009 to begin claiming amortization deductions, but only with respect to rented-out farmland that it had acquired and place in service beginning in 2004. While Conmac maintained that its change in tax reporting was based on a change in underlying facts, the court found that Conmac never identified what facts changed despite having ample opportunity to do so.

The court explained that a change in tax reporting generally will be attributable to a change in underlying facts, and not to a change in method of accounting, where the taxpayer continues to apply its existing method of accounting to a change in business practices, a change in economic or legal relationships, or an otherwise altered fact situation. In the court's view, none of that occurred in this case. The court observed that Conmac did not change its existing business practices; rather, it continued to serve as a landlord to tenant farmers. Nor did Conmac change any of its economic or legal relationships - for example, through modification of lease agreement terms. The court said that the only economic consequence appeared to be the tax benefit that Conmac received on account of the change.

The court distinguished the Fifth Circuit's decision in Brookshire Bros. on the grounds that in this case, Conmac did not file amended returns with an explanatory statement for all open years reclassifying the property at issue (i.e., the base acres rented to tenant farmers). Nor did Conmac adopt the same accounting treatment for all property within the same class of property (i.e., base acres). Instead, the court found that Conmac continued to treat base acres acquired and placed in service in other years as nonamortizable or nondepreciable. The court said that upholding an unauthorized change in accounting method in an instance like this would invite inconsistency in a context where consistency required, regardless of the method or system of accounting used. The court also found that sustaining the IRS's determination, which would merely return Conmac to its old accounting method that it chose to use for many years, did not offend basic fairness.

The court also sustained the IRS's Code Sec. 481 adjustment relating to Conmac's unauthorized amortization deductions. The court rejected Conmac's argument that the Code Sec. 481 adjustment was barred by the statute of limitations after finding that the "year of the change" in this case was the oldest open tax year. The court explained that a Code Sec. 481 adjustment may include amounts attributable to otherwise time-barred tax years and noted that the only limitation on Code Sec. 481(a) adjustments is that no pre-1954 adjustments may be made. The court noted that in Huffman v. Comm'r, 518 F.3d 357 (6th Cir. 2008), aff'g 126 T.C. 322 (2006), the Sixth Circuit explained that so long as a change in method of accounting has occurred, the IRS may adjust a taxpayer's income in an open year to reflect amounts attributable to years for which the applicable statute of limitations has expired.

For a discussion of changes that constitute a change in method of accounting, see Parker Tax ¶241,590.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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