Tax Benefit Rule Doesn't Apply to Inherited Farm Inputs Deducted in Year Paid and Year Used

(Parker Tax Publishing December 2016)

The Tax Court held that the tax benefit rule did not require the recapture upon a cash method taxpayer's death in 2011 of deductions taken in 2010 for his expenditures on the farm inputs. Thus, the taxpayer's wife was able to deduct an amount equal to the value of the farm inputs inherited from the taxpayer on her 2011 tax return. Est. of Backemeyer v. Comm'r, 147 T.C. No. 17 (2016).

Background

Steve Backemeyer was a sole proprietor farmer who used the cash method of accounting. In 2010, he purchased certain farm inputs (e.g., herbicides, seed corn, soybeans, fertilizers, etc.), intending to use them to cultivate crops the following year. He deducted the expense under Code Sec. 162 in 2010.

Steve died in March 2011 not having used any of the purchased farm inputs. They were subsequently transferred to his wife, Julie, who began her own farming business as a sole proprietor upon her husband's death. She used all the farm inputs in 2011 to grow crops that were then sold in 2011 and 2012. On her 2011 Schedule F, Julie reported various farming expenses, including expenses in amounts equal to those reported on her husband's 2010 Schedule F for farm inputs. Thus, Julie deducted an amount equal to the value of the farm inputs inherited from her husband on her 2011 tax return.

Upon auditing the Backemeyer's tax returns, the IRS denied the deduction Julie took for the farm inputs inherited from her husband. Citing the Supreme Court's decision in Bliss Dairy, 460 U.S. 370 (S. Ct. 1983), the IRS argued that, in view of Steve's death and the concordant transfer of the farm inputs to Julie, the tax benefit rule required that the deductions claimed in 2010 for the farm input expenditures be recovered in 2011. According to the IRS, since the couple used the cash method for their farming activity, prepaid expenses that were paid in 2010 are deductible in 2010 and are not added to basis.

In addition, the IRS assessed an accuracy-related penalty under Code Sec. 6662(a) of approximately $16,000 on the grounds of a substantial understatement of income tax, a valuation misstatement, or negligence or disregard of rules or regulations.

Analysis

In Bliss Dairy, the Supreme Court applied the tax benefit rule to require a dairy farm to recognize as income the value of business deductions taken during the previous year for cattle feed that ultimately was not fed to cattle but distributed to shareholders during the farm's liquidation. The Court stated that the premise of a Code Sec. 162(a) business deduction is that the item or service acquired will be consumed in the course of a trade or business. Accordingly, the Court held that the farm's liquidation distribution of unconsumed feed was fundamentally inconsistent with the premise on which the deduction of the feed was based. The Court applied the tax benefit rule to remedy the inconsistency, requiring the farm to recognize as income the value of the deduction taken for unconsumed feed distributed during liquidation. By the same token, the tax benefit rule did not require the farm to recognize as income the value of deductions taken for feed that was actually consumed prior to liquidation.

The Tax Court held that the tax benefit rule did not require the recapture upon Steve's death in 2011 of deductions he claimed for 2010 for his expenditures on the farm inputs.

The court agreed that Bliss Dairy was the keystone to resolving the issue in the instant case. The IRS's reliance on the case was not misplaced, the court said; rather its interpretation of it was erroneous. The court noted that in Bliss Dairy, the Supreme Court observed that the purpose of the tax benefit rule is to approximate the results produced by a tax system based on transactional rather than annual accounting. It is intended to achieve rough transactional parity in tax and to protect the government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous. The rule's application is not automatic, the Supreme Court said - it applies only when a careful examination shows that the later event is indeed fundamentally inconsistent with the premise on which the deduction was initially based. Thus, if that event had occurred within the same tax year, it would have foreclosed the deduction, the Supreme Court said.

The Tax Court noted that both Bliss Dairy and the instant case involved taxpayers in the farming industry. In both cases, taxpayers purchased farm inputs in one tax year, with those inputs being transferred to other taxpayers in the next. In both cases, taxpayers claimed deductions for their purchases of farm inputs. In both cases, the transferees also claimed deductions for the transferred farm inputs. And in both cases, the transfer was not subject to income tax. The key difference, the Tax Court observed, was that Bliss Dairy involved the nonrecognition of gain on a liquidating distribution by a corporation to its shareholders under Code Sec. 336, whereas in the instant case, the transfer occurred at death.

The court looked at its prior decision in Frederick v. Comm'r, 101 T.C. 35 (1993), in which it suggested a four-part test to determine whether the tax benefit rule applied to a particular situation. In that decision the court said that 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.

In the instant case, the court said that the first two criteria were met. The couple 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 fourth criteria were not met. With respect to the third criteria, the court said that neither Steve's death nor the distribution of the farm inputs to and their use by Julie was fundamentally inconsistent with the premises on which the initial deduction for 2010 was based. With respect to the fourth criteria, the court noted that nonrecognition on death is among the strongest principles inherent in the income tax. As a result, the Tax Court concluded that a transfer at death is not fundamentally inconsistent with the premise on which the couple's Code Sec. 162 deduction was initially based.

The court also concluded that the Code Sec. 6662 accuracy-related penalty did not apply since the couple's deductions of the inputs were appropriate.

For a discussion of the tax benefit rule, see Parker Tax ¶76,920.

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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