Steve Backemeyer, a cash basis farmer, purchased seed, chemicals, fertilizer and fuel in 2010 which he intended to use when planting crops in 2011. Being on the cash basis, these items were deducted on his 2010 income tax return, filing married filing joint with his wife. However, Steve died in March 2011 and these supplies were inherited by his wife. His wife took up the farming business, using these supplies to plant the crop in 2011. She claimed these items, valued as of the date of Steve’s death, as a deduction on her 2011 return, also a joint return filed with her deceased husband.
In the case of Estate of Steve K. Backemeyer et al v. Commissioner, 147 TC No. 17 the IRS argued that the tax benefit should prevent this double deduction of the same expenses for the same crop, requiring the deduction to be removed from the taxpayers’ 2010 tax return. But the Tax Court found that both deductions were allowed in this situation.
The IRS argued that the case was governed by the result in the Bliss Dairy v. United States case (460 US 370 (1983)). The Tax Court summarized that case as follows:
Bliss Dairy, 460 U.S. at 374, involved a closely held corporation which used the cash method of accounting and engaged in the business of operating a dairy. Close to the end of its taxable year, the corporation deducted on purchase the full cost of cattle feed bought for use in its operations. Id. Shortly after the beginning of its next taxable year, with a substantial portion of the feed still on hand, the corporation liquidated and distributed its assets to its shareholders in a nontaxable transaction. Id. at 374-375. The shareholders continued operating the dairy business in noncorporate form and in turn deducted their basis in the feed as an expense of doing business. Id. at 376. The Supreme Court held that the liquidation of the corporation resulted in conversion of the cattle feed from a business to a nonbusiness use, representing an action inconsistent with the prior deduction and requiring application of the tax benefit rule. Id. at 395-402.
The IRS argued that the same sort of conversion to nonbusiness use of the farm inputs occurred here. As the Court summarizes:
Respondent argues that the facts here are nearly identical to those of Bliss Dairy. When Mr. Backemeyer died not having used the farm inputs in his sole proprietor farming operation, respondent opines, the farm inputs were converted to a nonbusiness use when they were distributed to the Backemeyer Family Trust. When Mrs. Backemeyer received the assets, she took them with a stepped-up basis and contributed them to her sole proprietor farming business. Therefore, respondent asserts, upon Mr. Backemeyer's death the farm inputs were converted from business to personal use, and Mrs. Backemeyer converted them back from personal to business use. According to respondent, this entitles Mrs. Backemeyer to a deduction under section 162 but also requires Mr. Backemeyer to recognize income related to his conversion of the property from one use to another.
The taxpayer disagreed with this view. The Court summarized the taxpayer’s position as follows:
Much of petitioners' argument rests on the proposition that when Mrs. Backemeyer inherited the farm inputs from her late husband and used them in her own farming operation, she is deemed to have simultaneously sold the inputs and then purchased them for use in farming, with the deemed sale resulting in no gain because she had a full stepped-up basis in the farm inputs. Petitioners insist that they should be regarded separately with respect to the separate Schedules F that they filed for the 2011 tax year (respondent in his answering brief concedes this point). According to petitioners, the stepped-up basis with which Mrs. Backemeyer took the farm inputs gave her a "fresh start" with respect to the tax attributes of these inherited assets. Petitioners point out that this is "not some elaborate scheme to create a double deduction" but is an unusual circumstance that occurred as a result of Mr. Backemeyer's death.
The Tax Court found the IRS had misinterpreted Bliss Dairy in this case. The Court found that the proper way to view Bliss Dairy’s interpretation of the tax benefit rule is as follows:
In Bliss Dairy, 460 U.S. at 381, 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." Id. at 383. The rule's application is not automatic. 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." Id. This means that "if that event had occurred within the same taxable year, it would have foreclosed the deduction." Id. at 383-384.
The opinion noted that in case of Frederick v. Commissioner, 101 T.C. 35, 41 (1993) the Tax Court had outlined a four factor test that would determine if the tax benefit rule of Bliss Dairy should apply:
- The amount was deducted in a year prior to the current year,
- The deduction resulted in a tax benefit,
- An event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and
- A nonrecognition provision of the Internal Revenue Code does not prevent the inclusion in gross income.
The Tax Court notes that the first two tests are met in this case—the amount was deducted in 2010 and it resulted in a tax benefit.
But the Court found the nature of the operation of the estate tax and the inherited basis rules did create an event fundamentally inconsistent with the premises on which the original deduction was based. The Court notes:
The reason for this is that the estate tax effectively "recaptures" section 162 deductions by way of its normal operation, obviating any need to separately apply the tax benefit rule. When Mr. Backemeyer died, all of his assets, including the farm inputs, became subject to the estate tax, which operates similarly to a mark-to-market tax when the mark-to-market tax is imposed on zero-basis assets. Compare sec. 2001(a) (imposing a tax "on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States"), and sec. 2051 (defining the value of a taxable estate as the value of the gross estate less certain deductions provided for in the estate tax), and sec. 2031 (defining the value of a gross estate as the value at the time of decedent's death "of all property, real or personal, tangible or intangible, wherever situated"), with, e.g., sec. 877A (imposing an exit tax on U.S. citizens and long-term residents relinquishing citizenship or lawful permanent residence, respectively, by requiring that "[a]ll property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value"). The farm inputs were included in Mr. Backemeyer's estate at their fair market value, see sec. 2031, which the parties have stipulated to be equal to the farm inputs' purchase price. Since the farm inputs had a basis of zero, they were subject to the estate tax on the same base as their purchase price, for which Mr. Backemeyer had claimed a section 162 deduction for 2010.
The imposition of the estate tax meant that there was (in theory) a tax cost imposed when Mr. Backemeyer died. However, even if Mr. Backenmeyer’s estate exceeded the maximum that could generally pass tax free, the fact it went to Mrs. Backenmeyer meant that no tax would actually be imposed. However, that fact did not make a difference to the Tax Court in this case.
The Court also found that a death was fundamentally different from the liquidation transaction in Bliss Dairy. The Court notes:
Whereas liquidation of a corporation or a sale of expensed business inputs entails some level of forethought and affirmative intent to act accordingly, death ordinarily does not involve such planning. As the Court of Appeals for the Eighth Circuit has observed, while death may be beneficial for tax purposes, it is difficult to regard it as a tax avoidance scheme. Estate of Peterson v. Commissioner, 667 F.2d 675, 681-682 (8th Cir. 1981), aff'g 74 T.C. 630 (1980). Under the Supreme Court's Bliss Dairy standard, death is the quintessential "merely unexpected event." Were death fundamentally inconsistent with expensing business inputs, every sole proprietor in the year of his death would face double taxation under both the income tax and the estate tax on all the inputs he had purchased for but not yet used in his business. We are loath to interpret Bliss Dairy to stand for the proposition that any time a sole proprietor dies, all of his expensed assets are subject to recapture. The Supreme Court has refused to accept such a rule, see Bliss Dairy, 460 U.S. at 386 n.20, as do we.
The Court notes the double deduction that the IRS is worried about is triggered solely by IRC §1014(a):
The sole cause for the allowance of two deductions here is section 1014(a), which steps up the basis of property acquired from a decedent. Were section 1014 not to apply, then Mrs. Backemeyer would have received the farm inputs with a zero basis and therefore been unable to deduct them. We find it unlikely that respondent would have pursued his tax benefit rule argument were that the case. Since "Congress presumably enacts legislation with knowledge of the law," CRI-Leslie, LLC v. Commissioner, 147 T.C. ___, ___ (slip op. at 13) (Sept. 7, 2016), we conclude that had Congress wished to foreclose a second section 162 deduction as a result of a section 1014 basis step-up, it would have so provided.
The Court also notes that the fourth criteria is not met either, since the tax law provides that a disposition by death is not a recognition event—or, as the Court puts it, “nonrecognition on death is among the strongest principles inherent in the income tax.”