Cash Basis Farmer Can Expense Packaging Materials as Purchased Rather Than When Used, But Decision Based on Regulation Changed Substantially Beginning in 2014

This post has been revised to incorporate comments the author received regarding the potential application of Reg. §1.162-12 to resolve the issue independently of how the Court actually decided the case.

In Agro-Jal Farming Enterprises, Inc. et al v. Commissioner, 145 TC No. 5 the Tax Court was asked to determine if a farmer reporting on the cash basis of accounting could claim a deduction for packaging materials as payment was made for the materials or if the taxpayer rather could only deduct the amounts as the materials were used.

Decision of the Court

While Agro-Jal reported on the cash basis for tax purposes, it prepared GAAP basis financial statements for financing purposes and keep detailed records on the packaging supplies on hand at year-end, capitalizing those on its year-end financial statements.

The case is one of great interest to farmers—but the application of its specific holdings for most part ceased to be relevant for tax years beginning in 2014.

There are parts of the decision that are relevant.  The Court determined that the items in question were not “similar farm supplies” as defined in IRC §464.  IRC §464 applies to “farming syndicates” which generally were sold to high income taxpayers, restricting them from claiming a deduction for “feed, seed, fertilizer, or other similar farm supplies” until they are used in farming.

While both the IRS and the taxpayer agreed that the entity was not a farming syndicate (and thus not directly impacted by IRC §464), they both look to that section for other purposes.  According to the IRS §464 for a farm that is not a “farming syndicate” operates as an exception to the general requirement for delaying deduction of expenses under old Reg. §1.162‑3 until the item is used in the business.  Arguing that the packaging is not a “similar farm supply” the IRS claims it is not protected by §464 to allow an immediate deduction.

The taxpayer argues that, in fact, these packaging materials are just such similar supplies.  The Tax Court agreed with the IRS view that since the named items in the list (feed, seed and fertilizer) are using directly in production, that packaging material is not “similar” to those items and not covered by IRC §464. 

But the Court did not agree with the IRS that the then existing Reg. §1.162‑3 required delaying a deduction until the supply was used.  That regulation, prior to an amendment that was first effective for tax years beginning on or after January 1, 2014, provided:

Taxpayers carrying materials and supplies on hand should include in expenses the charges for materials and supplies only in the amount that they are actually consumed and used in operation during the taxable year for which the return is made, 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 year.

The IRS argued that the portion of that regulation before the first comma controlled and the remainder of the regulation simply denied a double deduction when the item had been improperly claimed.  The Tax Court did not accept that view—rather the Court agreed with the taxpayer that the provision the IRS was concerned with only applied if the deduction was not properly claimed in an earlier year.  As farmers are allowed to operate on the cash basis, the Court found that, so long as they had paid for the materials and they were used within one year (as they always were), the farm would get a deduction no later than when the materials were paid for.

Revised Regulation

This is all well and good except for one minor detail—as was noted above, this regulation was totally revamped in 2014 as part of the overall tangible personal property regulations.  Thus, aside from the §464 “farm supplies” discussion, most of this case appears to be not relevant for years beginning after January 1, 2014.

For those years the regulation now generally provides that materials and supplies (which would include the packaging materials under the useful live of less than 12 months rule) can be expensed when acquired unless the taxpayer tracks those materials—something that Agro-Jal does.

In particular current Reg. §1.162‑3(a)(1) provides that in the case of materials and supplies, “amounts paid to acquire or produce materials and…are deductible in the taxable year in which the materials and supplies are first used in the taxpayer's operations or are consumed in the taxpayer's operations.” 

An exception to this rule exists at Reg. §1.162‑3(a)(2) which provides for immediate expensing of materials and supplies “for which no record of consumption is kept or of which physical inventories at the beginning and end of the taxable year are not taken… provided taxable income is clearly reflected.”  Agro-Jal would not meet this requirement—as was noted in the case, the entity did keep detailed records of the packaging materials on hand.

There is one other exception—if a de minimis election is made pursuant to Reg. §1.263(a)‑1(f) then the amounts can be written off in some cases.  There are two variations of this exception, one for entities with “applicable financial statements” and another for those without. 

An applicable financial statement exists for an entity if it has at least one of the following for the tax year in question:

  • A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10-K or the Annual Statement to Shareholders);
  • A certified audited financial statement that is accompanied by the report of an independent certified public accountant (or in the case of a foreign entity, by the report of a similarly qualified independent professional) that is used for -
  • Credit purposes;
  • Reporting to shareholders, partners, or similar persons; or
  • Any other substantial non-tax purpose; or
  • A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or the Internal Revenue Service).

The applicable financial statement will be the first one of those listed above that the entity has.  If it has no such statement then it follows the rules for an entity without an applicable financial statement.

In this case if the entity makes a timely de minimis election for the year then it can charge off items with an invoice cost of less than $5,000 (for those with an applicable financial statement) or $500 (for those without) if certain conditions are met. The dollar limits would not be a problem regardless of which rule applies to this entity—strawberry baskets and such similar packaging supplies don’t go for anywhere $500, let alone $5,000, per unit.

But there is a problem here—if there is an applicable financial statement then the item must be expensed on that statement.  If Agro-Jal’s lender requires an audited statement then the fact the items are reported on the financial would eliminate any chance of using a de minimis election to charge off these items.

If Agro-Jal’s lender does not require an audited statement and the entity has no other applicable financial statement things get more interesting under the regulations.  Generally the procedures used by the company on it “books and records” are to be used—so if it expenses the items on its books then it could charge them off with a de minimis election even if it kept track of the number of items on hand.

Under Reg. §1.162‑3(f)(1)(ii)(B) the taxpayer must treat these items as an expense “for non-tax purposes.”  Clearly giving the financial to the bank is a non-tax purpose, but the regulation does not specifically say “for all non-tax purposes” which begs the question of whether the taxpayer could show other non-tax purposes to meet this requirement.  While that’s a possible argument, advisers should be aware that it’s very likely the IRS would not see things that way.

Nevertheless, it does appear under the revised Reg. §1.162‑3 that a farmer who writes the expense off immediately on the books and does not issue statements to any party that capitalizes packaging supplies on hand should be able to continue to expense these items using the de minimis election option—or even as non-incidental supplies if such materials are not counted (though that seems to be risking the potential of running out of such supplies with crops in the field that are not going to remain saleable long enough to order new supplies).

The one thing that should still be true, though, is that the answer to this question is going to come from Reg. §1.162‑3.  It should still control the answer, though the radical change to the wording of the regulation means the detailed analysis of that regulation in this case simply isn’t going to be helpful for calendar year 2014 and later tax years.  

Or Maybe Not

After the case came out, Roger McEowen called me to question whether there wasn't another key issue here that would impact farmers—Reg. §1.162‑12 which covers farming specifically.  He argues that the provisions of that regulation generally provide for a cash basis deduction for farmers—specifically the first sentence of Reg. §1.162‑12(a) which provides “A farmer who operates a farm for profit is entitled to deduct from gross income as necessary expenses all amounts actually expended in the carrying on of the business of farming.”  The regulation goes on to specifically allow a deduction for “ordinary tools of short life or small cost” which includes hand tools, shovels, rakes, etc.  His interpretation is that these packaging materials should be governed by this provision rather than the supplies provisions of newly revised §1.162‑3.

Certainly it appears that provision generally is in line with the “cash basis” allowance for farmers.  And, in general rules of regulatory interpretation we should be able to assume a situation specific regulation (which this one would be) would override a general purpose regulation (such as found at Reg. §1.162‑3).

Of some concern, though, is that the Tax Court itself did not use this regulation to dispose of the issue—and that this treatment survived review of the decision when it was determined it should be issued as a published decision.  In reviewed decision the opinion of the judge who heard the case wishes to issue, being deemed to decide a significant position in law that had not previously been dealt with, is read by the other members of the Tax Court who have input into that decision, deciding whether to accept the opinion, agree with the result but decide a concurring opinion is necessary to revise the analysis leading to the result, or disagree with the opinion.  In this case the opinion was accepted and no other opinions (either concurring or dissenting) were issued.

It is certainly possible that counsel for neither party raised the issue, though that would require looking at the party’s briefs (which Mr. McEowen is in the process of doing) to see if that was the case.  And clearly cases have been decided when no one ever brought up what was a clearly more relevant case. 

But in a reviewed decision it would seem that a judge who had dealt with many agricultural cases might decide a concurring opinion arriving at the same result via a different route might be advisable. For an example outside of the Tax Court, see the concurring opinion in the Federal Circuit’s recent BASR Partnership opinion.  There the concurring judge agreed in the result, but argued that the issue was not the Code Section that the main opinion and dissenting one looked it, but rather a wholly different one that resolved the matter on unrelated grounds.

As written the opinion relies entirely upon Reg. §1.162‑3 to dispose of the matter, a regulation that should not be relevant if Reg. §1.162‑12 controls and allows a deduction for cash basis taxpayers. There is the (unanswered by the Court) question of whether there is a reason why Reg. §1.162‑12 would not have been relevant for packaging materials.  But it is important to note that while it causes concern, attempting to rely on the Court’s silence when dealing with a matter can get an adviser in trouble very quickly.  The Court simply didn’t say.

As I see it, there are two possible explanations for this:

  • The Court determined that, in fact, packaging materials are not covered by Reg. §1.162‑12 and therefore the general purpose materials regulations are what controls so the Court was forced to resolve the issue on those grounds or
  • Since the IRS focus was on old Reg. §1.162‑3 and Court found that wouldn’t require capitalization since the amount was properly claimed in an earlier year, it simply decided the case on that basis. 

If the first explanation is the proper one, then the new regulation poses a potential change of treatment for these items that are neither direct production materials (the §464 items) nor small tools.

However, if the second explanation is the proper one, then nothing may have changed.  It is important to note the Court never actually addressed what impact Reg. §1.162‑12 would have on this matter.   

So where does that leave farmers?  At this point there appears to be a supportable argument that Reg. §1.162‑12 would cover farmers and that the new Reg. §1.162‑3 did not serve to change that treatment. Certainly it seems that many farmers have presumed over the years that this regulation did serve to protect these deductions and, since the regulation wasn’t changed, presumably the result should not have changed.  And, it’s important to note, we don't have a case that actually addressed the post-2014 rules which would be the point at which the Court would be forced to clearly state that the deduction is allowed pursuant to Reg. §1.162‑12.  So at this point it would not appear taking that position goes against any authority that did not exist prior to this case—and this case doesn’t deal with the current rule.

But it will be important to keep an eye on any further development or clarification regarding the interaction of new Reg. §1.162‑3 (which does not have the language that the Court used to decide this case) and the unchanged Reg. §1.162‑12.