Agricultural Operations and Deducting Expenses on Your Taxes
Updated: Jul 7
This post should not be construed as legal or tax advice*
For those who do not know, agriculture is the only industry that the Internal Revenue Service (IRS) allows to continue using the cash accounting method for tax purposes. Cash accounting is simply recognizing income when it is received and expenses when paid. For example, Stan harvests corn in 2014 and stores a portion of his crop. Stan sells a portion of the stored crop in 2015, and would not recognize that income on his taxes till 2015. Farms may also choose to use the other accounting method — the accrual method, used by all other industries. Accrual accounting is when you report income and expenses in the year they incur. The idea behind accrual accounting is to allow for the matching of income and expenses.
Why are farms allowed to continue to utilize cash accounting practices and not switch to accrual like other industries? Some have pointed to the fact that many producers do not have the accounting skills necessary to grasp accrual accounting and the move would require producers to incur costs from hiring an accountant or an outside accounting firm (Klinefelter, EB-5077). While I will save the pros and cons of cash accounting versus accrual accounting for the farm financial experts, today I want to discuss a recent tax court ruling on when expenses can be deducted when using cash accounting.
In Agro-Jal Farming Enterprise, Inc. v. Commissioner of Internal Revenue, the U.S. Tax Court considered when an agricultural operation could defer expenses for packing materials. The IRS argued the operation could only deduct the cost of the materials used in the tax year and defer the cost of the unused ones to the tax year when used. Agro-Jal disagreed and argued that the cost of packing materials could be deducted in the year purchased or the year utilized as long as Agro-Jal had not already deducted the expense.
Agro-Jal is a diversified operation producing strawberries, the main crop at issue with the Tax Court. Strawberries are picked and placed in pre-labeled plastic clamshells to save time. Because of concerns Agro-Jal could run out of the pre-labeled plastic clamshells during harvest, Agro-Jal orders in bulk and prepays for large quantities of the clamshells, as deliveries can often take two to four months. Because Agro-Jal uses the cash accounting method, the farm deducts the expenses for the plastic clamshells in the tax year purchased (regardless if used or not).
As discussed earlier, the issue in this case was the timing of the deduction for the clamshells. The IRS conceded that the packing materials were deductible and the farm could use the cash method. The sole issue was timing of the deduction.
The Tax Court focused on two issues in this decision. The first focused on Section 464 of the Internal Revenue Code and the other issue focused on an IRS regulation allowing for the deduction of expenses in the year utilized. The court started with Section 464 which applied to farming syndicates (more on those in a minute) allowing them to deduct “amounts paid for feed, seed, fertilizer, or other similar farm supplies.” IRS argued that packing supplies did not qualify under “other similar farm supplies” because packing supplies were not like feed, seed, and fertilizer. The IRS’s argument was basically to be considered “other farm supplies,” the supplies needed to be inputs for farm production and not just useful materials. The court agreed with this argument and held that packing materials did not fall under deductions allowed under Section 464.
Section 464 only applies to farming syndicates or farm investments with highly leveraged purchases of farm supplies utilized by rich investors. Agro-Jal did not qualify as a farming syndicate, Section 464 did not apply, and the court had to look at how the deduction applied under Section 1.162.3. Agro-Jal argued this section allows for a cost to be deducted in the year consumed as long as it was not deducted in a previous tax year. The court agreed with this argument and ruled in favor of Agro-Jal.
Why Do You Care?
Many of you out there probably use a cash accounting method and this court decision does help determine when you can make deductions for expenses. You may not be purchasing large quantities of packing materials like the taxpayers in the decision, but many of you pre-purchase supplies (maybe near the end of the tax year when you need a quick deduction). The decision helps settle for cash accounting a practice that goes on continually in agriculture. Stay tuned; there still is the option for the IRS to appeal this decision and the last may not have been written on this issue.
Agro-Jal Farming Enter., Inc. v. Comm’r of Internal Revenue, 145 T.C. 5 (T.C. 2015).
Klinefelter, Danny. “Farm and Ranch Financial Management: Cash vs. Accrual Accounting.” Texas AgriLife Extension, EB-5077. Internet site: https://www.agrilifebookstore.org/v/vspfiles/downloadables/EB-5077.pdf (last visited August 3, 2015).
*No one should ever take tax advice from Paul.