Farming Corporation Can Deduct Field-Packing Materials in Year Purchased.

(Parker Tax Publishing August 26, 2015)

Field-packing materials that a farming corporation buys that are "on hand" are governed by Reg. Sec. 1.162-3, which does not require a cash-method taxpayer to defer its deductions until the materials are used or consumed if the taxpayer deducted such costs for a prior tax year. Agro-Jal Farming Enterprises, Inc. v. Comm'r, 145 T.C. No. 5 (2015).

OBSERVATION: In 2012, the IRS revised Reg. Sec. 1.162-3 as part of its overhaul of the tangible property rules. Generally, under the revised rules, amounts paid to acquire or produce nonincidental materials and supplies are deductible in the tax year in which the materials and supplies are first used or consumed in the taxpayer's operations. Amounts paid to acquire or produce incidental materials and supplies that are carried on hand and for which no record of consumption is kept or of which physical inventories at the beginning and end of the tax year are not taken, are deductible in the tax year in which these amounts are paid, provided that taxable income is clearly reflected.

Background

Agro-Jal Farming Enterprises, Inc. is a farming corporation that grows strawberries and vegetables. When it harvests them, Agro-Jal uses field-packing materials (plastic clamshell containers for the strawberries and cardboard trays and cartons for the vegetables) to hold the produce. Agro-Jal's ability to pack quickly would be significantly weakened if it didn't keep field-packing materials on hand. The packing materials are always used by the end of the tax year following the year in which they are purchased.

Agro-Jal uses the cash method for tax purposes. In 2006-2008, Agro-Jal deducted the full purchase price of the field-packing materials in the year it purchased the materials rather than deducting the amounts as the materials were used.

The IRS assessed a deficiency, arguing that, under Code Sec. 464 and Reg. Sec. 1.162-3 (as the regulation existed in 2006-2008), Agro-Jal could only deduct the cost of the field-packing materials in the years in which they were used.

Taxpayer and IRS Arguments

Code Sec. 464 limits the ability of "farming syndicates" and those who are not "qualified farm-related taxpayers" to use the cash method. While the IRS did not argue that Agro-Jal was a farming syndicate, it looked to the exceptions to capitalization in Code Secs. 464(a) and (f) (which allow immediate deductions for feed, seed, fertilizer, or other similar farm supplies when the amounts prepaid for such expenses don't account for more than 50 percent of all farming expenses during any three-year period) and said they didn't apply to Agro-Jal. While the phrase "other similar farm supplies" is not defined anywhere, the IRS argued that it should be narrowly construed to not include Agro-Jal's field-packing materials.

Reg. Sec. 1.162-3, for the years at issue, provides that taxpayers carrying materials and supplies on hand should include in expenses the charges for materials and supplies only in the amount actually consumed and used in operations during the tax year, PROVIDED THAT the costs of such materials and supplies have not been deducted in determining the net income or loss or taxable income for any previous tax year.

Agro-Jal contended that because it already deducted its materials and supplies in an earlier year - the year it bought them--it wasn't required to defer its deduction until the year the supplies were used or consumed. The company noted that the general rule is that farmers can use the cash method for supplies they use within a year of purchase, but Reg. Sec. 1.162-3 creates a significant exception to that rule. However, Agro-Jal contended, this exception doesn't apply to cash-method taxpayers who meet the condition set forth in the "provided that" clause. If a taxpayer has already deducted costs of supplies for a prior year, Argo-Jal said, the taxpayer isn't subject to the first clause. According to Agro-Jal, the second clause is important to ensure that a deduction is not taken twice by those using the cash method. The first sentence of Reg. Sec. 1.162-3, the company argued, merely emphasizes the need to bar a second deduction for the same supplies when a taxpayer actually uses them in a later year, but doesn't require taxpayers to defer deductions until consumption. Agro-Jal concluded that its interpretation must be correct, because the "provided that" clause would be meaningless if it wasn't read as a conditional limit on the reach of the first clause.

According to the IRS, the "provided that" clause should be read as a limitation or qualification to prevent a double deduction. The IRS said that Agro-Jal's reading of the second clause deprives the first clause of any effect in the case of a cash-method taxpayer while the IRS's reading gives meaning to the whole regulation and produces a logical result.

Analysis

The Tax Court held that Agro-Jal could deduct the cost of the field-packing materials in the year purchased. According to the court, the packing materials that Agro-Jal buys that are not "on hand" are governed by the general rules of cash-method accounting, which allows a current deduction. The court said that the materials that Agro-Jal buys that are "on hand," like the field-packing materials, are governed by Reg. Sec. 1.162-3, which the court concluded does not require a cash-method taxpayer to defer its deductions until the materials are used or consumed if the taxpayer deducted their costs for a prior tax year.

The court held that the "provided that" clause of Reg. Sec. 1.162-3 means that materials and supplies must be deducted as they are used or consumed, on the condition that (or "only if", or "as long as") they haven't been deducted in any prior year. The court agreed with Agro-Jal's interpretation of the phrase "provided that" as used in Reg. Sec. 1.162-3 as meaning that Agro-Jal has to defer its deductions until it uses or consumes the field-packing materials "only if" it didn't deduct them in any prior year.

The court did agree with the IRS, however, on its argument that the term "other similar farm supplies" in Code Sec. 464 did not include Agro-Jal's field-packing material. When a general word or phrase follows a list of more specific words, the court said that the general word or phrase should be narrowly construed to include only things that are akin to the specific words. The court said that, while it didn't doubt that Agro-Jal's field-packing materials were of critical importance to its harvesting process and its overall business operations, the materials weren't critical to the growing of crops or the raising of livestock. Thus, the court concluded that they were not similar enough to the class of items described by the phrase "feed, seed, [or] fertilizer."

For a discussion of the general rule for deducting payments for materials and supplies, see Parker Tax ¶242,705. (Staff Editor Parker Tax Publishing)

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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