General Livestock

Table of Contents

• Chapter 1, Introduction
  • Purpose of the Guide
  • Keeping in Touch with the Industry
  • Compliance Potential
  • General Livestock Risks
  • Changes in Methods of Accounting
  • Conclusion

• Chapter 2, Examination Techniques
  • Pre-Planning
  • Document Request/Appointment Schedule
  • Initial Interview
  • Site Visit
  • Audit Steps
  • Closing Conference
  • Conclusion

• Chapter 3, Industry Issues
  • Common Issues
  • Breeder Operation
  • Fattening/Feeding Operation

  • Issues
    • IRC section 1231
    • IRC section 162
    • IRC section 61
    • IRC section 168
    • IRC section 179
    • IRC section 183
    • IRC section 195
    • IRC section 451
    • IRC section 465
    • IRC section 469
    • IRC section 471
    • IRC section 1033

  • Conclusion
  • Unique Characteristics

• Chapter 4, Cattle Industry
  • Introduction
  • Industry Facts

  • Issues
    • IRC section 162
    • IRC section 61
    • IRC section 168
    • IRC section 469

• Chapter 5, Dairy Cattle Industry
  • Introduction
  • Industry Facts
  • Issues
    • IRC section 61
    • IRC section 168

• Chapter 6, Horse Industry
  • Introduction
  • Industry Facts
  • Issues
    • IRC section 1231
    • IRC section 61
    • IRC section 168

• Chapter 7, Sheep And Goat Industry
  • Introduction
  • Sheep
  • Goats
  • Industry Facts
  • Issues
    • IRC section 162
    • IRC section 61
    • IRC section 168

• Chapter 8, Swine Industry
  • Introduction
  • Industry Facts

  • Issues
    • IRC section 168

• Chapter 9, Ratites And Alternative Livestock Industry
  • Ratites
    • Introduction
    • Industry Facts
    • End Products

  • Issues
    • IRC section 1231
    • IRC section 61
    • IRC section 168
    • IRC section 179
    • IRC section 195
    • IRC section 469

  • Alternative Livestock
    • Introduction

  • Issues
    • IRC section 1231
    • IRC section 61
    • IRC section 168
    • IRC section 179
    • IRC section 195
    • IRC section 469

• Appendix - A, Glossary-Livestock Terms
  • Quick Facts Related to Livestock Farming
    • Cattle
    • Horses
    • Sheep
    • Swine
    • Mink Farming

  • Glossary

• Appendix - B, Interview Questions - By Type
  • Introduction
  • Farm Initial Interview
  • Beef Interview Questions
  • Dairy Interview Questions
  • Swine Interview Questions
  • Sheep Interview Questions
  • Exotic Animal Interview Questions

• Appendix - C, Other Sources Of Information
  • MSSP Audit Guides
  • Publications
  • Periodicals and Non-IRS Publications

• Appendix - D, Livestock Breed Associations
  • Ass Breed Associations
  • Cattle Breed Associations
  • Goat Breed Associations
  • Horse Breed Association
  • Sheep Breed Associations
  • Swine Breed Associations

• Appendix - E, United States Department Of Agriculture
  • Electronic Sources of Information

These research tools can be accessed quickly and serve to develop a feel for the breadth of the scope of your audit. The depth is determined by other factors which may not be obvious in the preplanning phase. However, the following items may indicate the need for depth:

FEED -- high cost when a related supplier or feedlot is involved.

DEATH -- loss deducted separately from cost of goods sold - determining if this cost is duplicated can be an extensive process.

CERTAIN COMBINATIONS -- if seed and chemical costs or pasture rent are high, this indicates a grazing operation which points to potentially atypical sales sources.

Evaluate the audit classification sheet, if available. More and more MSSP returns are being classified by specialists who provide helpful suggestions or comments about certain issues on the return. Use this information to develop your pre-plan realizing that there may be considerations for your area that supplement these suggestions and result in more reasonable evaluation of the return.

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Document Request/Appointment Schedule

The initial contact, your own experience, and the preferences of management in your office or district will determine the extent of your initial document request. Whether you request a basic set of information or highlight identified issues requesting specific records, your goal is to ensure the old adage, "well begun is half done." Get what you need to do the job efficiently and effectively. Keep your audit moving to eliminate over-aged and short-statute cases.

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Initial Interview

Depending on your auditing style, manager's preference and experience, you may want to interview the taxpayer early in the audit or you may want to review books and records prior to an interview to develop a course of questioning which will yield the greatest benefits in the shortest time. As a rule of thumb, it would be more helpful to interview the taxpayer early if they were heavily involved in the bookkeeping process and could provide guidance into the books and records. If the accountant prepares a "write-up" from bank statements or other records of the taxpayer, then it would be best to develop questions based on specifics in the books and records first before visiting with the taxpayer.

Every interview training session you have had has stressed the benefits of getting the taxpayer to talk openly, not just answer questions. By opening up to general conversation, more knowledge is gained than by direct questioning. Keep the questions open ended to encourage discussion rather than simple answers.

The most important information to derive is how the taxpayer conducts his or her business. Whether it includes breeding/raising/selling or buying/fattening/selling makes a tremendous difference. Hands-on activity or use of boarding or feedlots can mean a great deal toward the reasonableness of the return.

In short, DO NOT presume to know the business procedures of one farmer/rancher by having dealt with another. Learn how each individual taxpayer conducts business in order to audit properly that taxpayer.

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Site Visit

Watch for the same things in this site visit as with any other;

1. evidence of financial status,
2. equipment usage,
3. undisclosed aspects of the operation, etc.

Apply what you see to the return and related documentation. The observable aspects of the taxpayer operation help bring the picture together.

Audit Steps

Corporate M-1/M-2 evaluation and a balance sheet analysis give an indication of whether certain types of expected adjustments were made or if any unusual handling of information is apparent from the return. Missing adjustments on M-1 or finding large, unusual or questionable entries on the balance sheet will initiate further questions and examination procedures.

Comparative analysis of prior and subsequent year return information can highlight procedural changes which result in variations in reported income or deductions. Though changes in classification of expenses may not make a difference in the net income, it could represent an effort to disguise some non-qualifying activity. Appearance or disappearance of investments or functions may lead to the determination of unreported income from dispositions or a source of income previously undisclosed.

Reconciliation of books to return requires the visual inspection of all aspects of the return which helps to put these components into perspective. Think about the reasonableness of all entries as they pertain to the operations.

Examination of detailed records which substantiate questioned items from the return will provide the basis for allowance or disallowance of specific entries. Due to the volume of information for certain areas, sampling or monthly testing may yield confidence in the reported area or validation that additional examination is necessary.

Use appropriate examination techniques. Is it acceptable per the risk analysis to go after every dollar misreported on a return, or should certain adjustments be accepted as "substantially correct" in light of the cost to pursue those adjustments?

Consider the necessity of penalties. Is compliance served by pursuing certain penalties? Is there reasonable care evident in the filing of the return or should the accuracy penalty be applied? Are there affirmative acts or indicators which require the consideration of the fraud penalty? How does the preparer's participation affect the result of the audit and should there be any penalty considered against the preparer?

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Closing Conference

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Chapter 3 - Industry Issues

Of the resulting offspring, generally only the females will be kept to build the breeding base. In some cases, the offspring will be raised to sell as breeders to other operations. Breeding females will often be sold with offspring as proof of reproductive ability. Otherwise, offspring will likely be sold for fattening/slaughter. In other cases, the farmer/rancher will raise the offspring to slaughter stage completely.

After the animals pass the practical breeding age, undesirable characteristics may begin to appear so breeding stock will be sold. Fresh stock will have been developed from the breeding process or purchased to continue the operation.

In the case of specialized animals, usually a registered breed, the initial acquisition process will be similar to the general breeding operation, except that both males and females will be registered. These breeding animals are highly controlled with the offspring being registered at birth to validate breeding lineage and to increase salability. In addition to the offspring being sold, semen and embryos may be sold as well. Sale of any of the animals results in the transfer of the registry information as recorded by the appropriate breed association.

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Fattening/Feeding Operation

If raised to the next level of maturity, these animals will normally be sold in small lots of several animals. This may be done through a sale barn/stockyard or individually to another rancher. When fattened for slaughter, the animals may continue to be grazed or, more likely, moved to a feedlot.

Tight control is kept on the animals when moved to the feedlot. Because the feedlot charges by the animal/by the day and must act responsibly for the well being of the animals up to the time they are moved from the feedlot, their recordkeeping is extensive. Tracking weight to justify the feed charges and monitoring health when weight is not reacting as predicted, there is little likelihood that these records would not be available. Determining the number of animals placed in the feedlot along with the source and disposition of the animals is essential to determining income.

Most slaughter houses and packing plants have buyers making the rounds to the feedlots and selecting animals for purchase. The purchase offer is either accepted by the feedlot as agent for the rancher or communicated to the rancher for consideration. If the offer is accepted, the sale is completed with detailed sales documents provided. The rancher settles up with the feedlot for any pending expenses on the lot(s) sold.

Animals determined to be undesirable will be set aside and are usually sold through special sales or to certain slaughterhouses for purposes other than human consumption. Sales documentation from those buyers is also available.

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Issues

IRC section 1231(b)(1) provides a general rule defining the term "property used in the trade or business" (section 1231 property). This general rule does not apply to livestock. The general rule restricts the definition of "property used in the trade or business" to, among other things, depreciable property, held for more than 1 year, "which is not (A) property of a kind which would be includable in the inventory of the taxpayer if on hand at the close of the taxable year, [or] (B) property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, * * *."

The special definition that is used in the case of livestock is found in IRC section 1231(b)(3) which defines "property used in the trade or business" as including "(A) cattle and horses, regardless of age, held by the taxpayer for draft, breeding, dairy, or sporting purposes, and held by him for 24 months or more from the date of acquisition, and (B) other livestock, regardless of age, held by the taxpayer for draft, breeding, dairy, or sporting purposes, and held by him for 12 months or more from the date of acquisition. Such term does not include poultry. "

Treas. Reg. section 1.1231-2(a) states: "(3) For the purposes of section 1231, the term 'livestock' is given a broad, rather than a narrow, interpretation and includes cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals, and other mammals. However, it does not include poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, reptiles, etc."

See chapter 11 of Publication 225, Farmer's Tax Guide, for a discussion of various types of dispositions. The following represents a basic indication of reporting requirements for certain types of sales.

Class of Animal	Type of Asset	Sale Reporting
Purchased for breeding	Depreciable when placed in service, IRC section 1231 property	Form 4797 -- asset used in trade or business
Offspring raised for breeding purposes	IRC section 1231 property generally zero basis	Schedule D -- before placed in service, Form 4797
Offspring raised for sale as breeder	Ordinary income asset	Schedule F -- sale of raised animals
Offspring sold as cull	IRC section 1231 property	Form 4797
Young animal purchased to feed to mid-maturity	Ordinary income	Schedule F -- sale of animal purchased for resale
Animal purchased to feed to final slaughter	Ordinary income asset	Schedule F -- sale of animal purchased for resale

There may be exceptions to some of the examples in the preceding table. Whether livestock is held for draft, breeding, dairy, or sporting purposes depends on all the facts and circumstances in each case. See Treas. Reg. section 1.1231-2(b)(1).

Only livestock (property) "used in the trade or business" qualifies for IRC section 1231 handling. Any animals purchased for resale must be included in inventory and its cost is recovered at the time of sale. The classification of income as Schedule F or IRC section 1231 affects the computation of self-employment tax.

Animals sold which were purchased for breeding purposes but not yet placed in service are not depreciable, but are considered to be held for use in the trade or business and qualify for IRC section 1231 reporting. In a business which includes both breeding and purchasing for resale, carefully determine the purpose for which the animals were purchased.

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IRC Section 162

Costs of feeding, handling, and caring for animals in either a breeding or fattening operation are current expenses and deductible currently.

If livestock die from disease, are destroyed because of disease, or are sold or exchanged because of disease, even though the disease is not of epidemic proportions, such occurrences are treated as involuntary conversions. No deduction is allowed for value of raised livestock that die if the cost of raising them has been deducted as an expense. Death of depreciable animals are not reported on Schedule F.

Farm labor issues may involve "payment in kind." A market segment understanding (MSU) has been issued regarding farm labor when payment is in the form of a product of the farm. The text of the MSU can be located on the IS/MSSP bulletin board, MSSP files, Agricultural related, as "M1PIC.ZIP" and can be downloaded. The title of the document is NONCASH REMUNERATION FOR AGRICULTURAL LABOR IRC. SECTION 3121(a)(8)(A). Private letter rulings 9202003 and 9322003 deal with this issue and provide some notable descriptive applications.

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IRC Section 61

Depreciation Methods

1. The 150-percent declining balance method over the GDS recovery period, which switches to the straight line method when that method provides a greater deduction,
2. The straight line method over the GDS recovery period,
3. The 150-percent declining balance method over fixed ADS recovery periods, which switches to the straight line method when that method provides a greater deduction, or
4. The straight line method over fixed ADS recovery periods.

Revenue Procedure 87-56 states that for property not described in any asset class life or used in a described activity, a 7-year class is assigned for the general MACRS method (GDS) and 12-year recovery period for ADS.

Immature livestock acquired for draft, dairy, or breeding purposes, is eligible for depreciation when it reaches maturity. This means depreciation begins when it reaches the age when it can be worked, milked, or bred. When this occurs, basis for depreciation is the initial cost for the immature livestock plus freight and other costs related to the acquisition.

Since the expenses of raising animals are deductible currently, there is no depreciable basis, and therefore, no depreciation for animals raised and used in a trade or business.

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IRC Section 179

1. Tangible personal property,
2. Other tangible property (except most buildings and their structural components), used as:
   1. An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services, or
   2. A research facility in any of the activities in (a) for the bulk storage of the fungible commodities, or
   3. A facility in any of the activities in (a) for the bulk storage of fungible commodities (including commodities in a liquid or gaseous state).
3. Single purpose agricultural (livestock) or horticultural structures (defined later), and
4. Storage facilities (excluding buildings and their structural components) used in distributing petroleum or any primary product of petroleum.

Agricultural structure. A single purpose agricultural (livestock) structure is any building or enclosure specifically designed, constructed, and used to:

1. House, raise, and feed a particular type of livestock and its produce, and
2. House the equipment, including any replacements, needed to house, raise, or feed the livestock.

Tangible personal property is tangible property other than real property. Machinery and equipment are examples of tangible personal property.

Land and land improvements, such as buildings and other permanent structures and their components, are real property and not tangible personal property. Swimming pools, paved parking areas, wharfs, docks, bridges, fences, and similar property are not tangible personal property.

All business property, other than structural components, contained in or attached to a building is tangible personal property. Under certain local laws, some tangible personal property cannot be tangible personal property for purposes of IRC section 179, and some real property under local law, such as fixtures, can be tangible personal property for IRC section 179 purposes. Property, such as milk tanks, automatic feeders, barn cleaners, and office equipment, are tangible personal property.

Livestock is qualifying property. For this purpose, livestock includes horses, cattle, hogs, sheep, goats, and mink and other furbearing animals.

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IRC Section 183

In determining whether a farming activity is carried on for profit, all the facts in regard to the activity are taken into account. No one factor alone is decisive. Publication 225 provides guidance to taxpayers who are analyzing their situation. Among the factors listed:

1. Is the farm operated in a businesslike manner?

2. Does the time and effort spent on farming indicate an intent to make it profitable?

3. Is there a dependence on income from farming for livelihood?

4. Are losses due to circumstances beyond control? Are the losses normal in the start-up phase of farming?

5. Are methods of operation changed in an attempt to improve profitability?

6. Are profits from farming made in any year and in what amounts?

7. Does the taxpayer, or advisors, have the knowledge needed to carry on the farming activity as a successful business?

8. Has the taxpayer made a profit in similar activities in the past?

9. Is the farming activity carried on for personal pleasure or recreation?

Look at the following court cases where the disallowance of expenses for not-for-profit activities was upheld:

Hendricks, Daniel E, et ux. v. Commissioner, 32 F.3d 94 (4th Cir 1994), 74 AFTR2d Par. 94-5281
surgeon with cattle operation

Westbrook, Billie R, et ux. v. Commissioner, 68 F.3d 868 (5th Cir 1995), 76 AFTR2d Par. 95-5623
veterinarian with embryo transplant, cattle and miniature horse operation

DeMendoza, Mario G, III v. Commissioner, T.C. Memo. 1994-314
lawyer with polo ponies

Borsody, Frank J, et ux. v. Commissioner, T.C. Memo. 1993-534 aff'd per curiam, US-CT-APP-4 [96-2 USTC _50,415], 78 AFTR2d Par. 96-5260
horse breeding/training

Lujan, Arthur G, et ux. v. Commissioner, T.C. Memo. 1992-417
retired with small cattle operation.

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IRC Section 195

Extract

(c) Definitions

For purposes of this section--

1. Start-up expenditures. The term "start-up expenditure" means any amount --
   1. paid or incurred in connection with --
      1. investigating the creation or acquisition of an active trade or business, or
      2. creating an active trade or business, or
      3. any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, and
   2. which, if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the trade or business referred to in subparagraph (A)), would be allowable as a deduction for the taxable year in which paid or incurred.

The term "start-up expenditure" does not include any amount with respect to which a deduction is allowable under section 163(a), 164, or 174.

To determine the timing of deduction for amortization, IRC section 195(c) goes on to say:

(2) Beginning of trade or business.

1. In general. Except as provided in subparagraph (B), the determination of when an active trade or business begins shall be made in accordance with such regulations as the Secretary may prescribe.
2. Acquired trade or business. An acquired active trade or business shall be treated as beginning when the taxpayer acquires it.

There are conflicting opinions as to the applicability of IRC section 195 to "new" farmers. Some authorities feel that a taxpayer is not yet engaged in the animal breeding business until the animals are placed in service as breeding stock.

This issue is unsettled (See IRC section 195, Treas. Reg. Section 1.162-12, and the repeal of the capitalization rules under 263A for pre-productive expenses on animals in the Technical & Misc. Revenue Act of 1988).

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IRC Section 451

Unusual circumstances have been addressed in IRC section 451(e) which provides:

Extract

IRC section 451(e)

1. In general. In the case of income derived from the sale or exchange of livestock in excess of the number the taxpayer would sell if he followed his usual business practices, a taxpayer reporting on the cash receipts and disbursements method of accounting may elect to include such income for the taxable year following the taxable year in which such sale or exchange occurs if he establishes that under his usual business practices, the sale or exchange would not have occurred in the taxable year in which it occurred if it were not for drought, flood, or other weather-related conditions, and that such conditions had resulted in the area being designated as eligible for assistance by the Federal Government.
2. Limitation. Paragraph (1) shall apply only to a taxpayer whose principal trade or business is farming (within the meaning of section 6420(c)(3)).

Notice 89-55, 1989-1 C.B. 696 further discusses this election.

Establishing the number of livestock the taxpayer would sell if he or she followed his or her usual business practices is the responsibility of the taxpayer to our satisfaction. Records of sales from prior years must be examined to determine the accuracy of the elected deferral. Materiality of the deferral will determine the depth of such examination.

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IRC Section 465

At-Risk Limits

"At-risk" generally includes:

1. The amount of money and property contributed to an activity.
2. The amounts borrowed for use in the activity if:
   1. taxpayer is personally liable for repayment of the amounts borrowed, or
   2. property not used in the activity secures the amounts borrowed.

"At-risk" does not include amounts borrowed for use in a farming activity from a person who has an interest in the activity or a person related to someone (other than taxpayer) having such an interest. For more information, see Publication 925.

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IRC Section 469

Material Participation vs Passive Activity

These questions will arise in the case of anyone whose primary occupation is other than farming and losses are present. If the professional activities prevent the dedication of time necessary to be successful in the business of farming, it is more likely that the taxpayer is unable to meet the material participation requirements of the law. Additionally, losses used to offset other income sources may be for that purpose only, rather than for profit.

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IRC Section 471

Further descriptions and related application of these methods is included in Treas. Reg. sections 1.471-6(d) through (h).

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IRC Section 1033

IRC section 1033(d) provides application to livestock destroyed by disease. Treas. Reg. section 1.1033(d)-1 details the application.

For livestock sold on account of drought, flood, or other weather-related conditions see IRC section 1033(e) (as amended in 1997) and Treas. Reg. section 1.1033(e)-1 for detailed information. Develop the facts of the taxpayer's case in the manner outlined in Treas. Reg. section 1.1033(e)-1(e):

1. Evidence of the existence of the drought, flood, or weather-related conditions which forced the sale or exchange of the livestock;
2. A computation of the amount of gain realize on the sale or exchange;
3. The number and kind of livestock sold or exchanged; and
4. The number of livestock of each kind that would have been sold or exchanged under the usual business practice in the absence of the drought.

Additionally, it will be necessary to determine the replacement assets. Treas. Reg. section 1.1033(e)-1(d) indicates "the replacement requirements of IRC section 1033 will be satisfied only if the livestock sold or exchanged is replaced within the prescribed period with livestock which is similar or related in service or use to the livestock sold or exchanged because of drought, that is, the new livestock must be functionally the same as the livestock involuntarily converted. This means that the new livestock must be held for the same useful purpose as the old was held. Thus, although dairy cows could be replaced by dairy cows, a taxpayer could not replace draft animals with breeding or dairy animals."

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Conclusion

In addition to this guide, a primary source of information to you should be the "expertise" which surrounds you. By utilizing the knowledge available in your office from your manager, senior agents and other co-workers, you are accessing one of the greatest resources available to you. During our tenure as agents and auditors we not only develop knowledge of a particular industry, but also practices of that industry in the area, reputation of taxpayers and preparers, and the ability to recognize questionable areas on returns.

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