Publication Date - July 2006

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Chapter 3/ Table of Contents / Chapter 5
Tax Code, Regulations and Official Guidance

Chapter Four - Expenses

• Introduction: Farm Business Expenses
• Related Entities
• Capital vs. Reoccurring Costs
• Contract Labor
• Outside Services Informational Sources

Capital vs. Reoccurring Costs

Land Preparation

The proper tax treatment of costs incurred in a farming operation depends on whether the amount expended represents a deductible expense or a capital expenditure. Most expenses attributable to profit-seeking farm activities are deductible as either business expenses or as production-of-income expenses (IRC § 162 & 212).

A capital cost is paid or incurred for the acquisition, improvement, or restoration of an asset having a useful life of more than one year. Capital expenses are generally not deductible, but they may be depreciable (IRC § 263). Uniform capitalization rules also require you to capitalize or include in inventory certain expenses (IRC § 263A).

The costs of the following items are costs you must capitalize. The costs of material, hired labor, and installation of these items must also be capitalized.

1. Water wells (including drilling and equipping costs)
2. Preparatory costs such as:
   1. Clearing land for farming (survey and layout of field)
   2. Leveling and conditioning land (fumigation and discing)
   3. Purchasing and planting trees and vines (digging)
   4. Building irrigation canals and ditches
   5. Laying irrigation pipes and installing drain tile
   6. Modifying channels, streams and dams
   7. Constructing earth, masonry or concrete tanks and reservoirs
   8. Fertilizer and lime application benefits that last substantially longer than one year (except for election of IRC § 180)

Common reoccurring land expenses are current farm deductions in the year in which they are paid or incurred where the benefits generally do not last substantially longer than one year (but only after the plants are producing in marketable quantities).

1. Pesticides, herbicides, and other chemicals applied to crops or farmland yearly
2. Insecticide spraying and dusting
3. Discing for weed control and for ground maintenance
4. Fertilizer, lime and other materials that enrich, neutralize, or condition farmland

For information to help you determine which pesticides are preparatory land costs or reoccurring costs, contact the local county Agricultural Commissioner’s Office. They will also have information regarding pesticide use permits.

Another source of information is the state university agricultural publications. The following data is an example of the information contained within one of their publications entitled “To Establish a Vineyard and Produce - RAISINS.”

Site Preparation
The land is subsoiled twice to a depth of 2 -3 feet, breaking underlying plowpan or hardpan to improve root and water penetration. Afterwards the ground is disced twice to break up large clods of soil, smoothing the ground in advance of leveling.  Leveling consists of three passes with a landplane. The bare ground is fumigated, to control soil nematodes and pathogens. All of the land preparation operations are contracted out to commercial companies. Most operations that prepare the vineyard for planting are done in the year prior to planting.

Planting
Planting the vineyard starts by laying out and marking vine sites in late winter. Holes are dug and vines are planted. About 605 vines are planted per acre during the first spring.  In the second year, 25 vines per acre are replaced due to damaged vines, etc..

Following planting, a pre-emergent residual herbicide is applied for weed control through most of the first year growing season.

Vineyard Floor Management
Weed control in the vine row and middles are managed with multiple discing and herbicides. The row middles are disced from March through August. A total of four discings per season are included. The vine rows are strip-sprayed with different combinations of pre-emergent herbicides during winter each year.

Occasionally, an issue arises regarding a farmer’s expensing of costs associated with leveling or otherwise preparing land for use. Most of these questions have been resolved by IRC § 175.

Section 175 provides that if a taxpayer is engaged in farming, expenses incurred for soil and water conservation may be deducted as a current business expense. The Regulation provides further clarification on this issue.

The Tax Court, in Estate of Straughn v. Commissioner, 55 T.C. 21 (1970), went further to state that the expenses of leveling land, breaking up the “hardpan” below the surface, were deductible even though it made the farmland usable for many crops for which it was not previously suited. The Court found the fact that the land had been used for farming prior to the taxpayer’s purchase of the land made the costs deductible in the year incurred. In Straughn, the Court stated that the law provided for the deduction, if the land had been used for farming (i.e. the planting of crops of any kind, not the raising of livestock). Therefore, if the use of the land goes from growing one kind of crop to growing any other kind of crop, it would appear to be acceptable to expense the costs associated with soil and water conservation.

However, if the land had not been used for farming immediately prior to the time the conservation measures were undertaken, we could argue that the costs are capital costs of readying the land for farming use. In Amfac, Inc. v. Commissioner, 626 F. 2d 109 (9th Cir. 1980), the Tax Court disallowed the claimed expenses. The Court found that a company had used the land for farming at a prior time, but it was long before the recorded history of the company. The Court found that this was just simply too long.  However, in Behring v. Commissioner, 32 T.C. 1256 (1959), the Tax Court found a company’s cost of leveling farmland for planting was not capital when the land had previously been used for farming, even though the land had not been used for farming in 30 years.

Written recommendations are required for many pesticides and are made by licensed pest control advisors.  For information and pesticide use permits, contact the state or local county Agricultural Commissioner’s Office. For additional production information, contact one of your local viticulture farm advisors.

The following table was prepared by University of California Cooperative Extension as sample costs to establish a vineyard and produce Thompson Seedless Raisins in the San Joaquin Valley of California in 2003.

Labor Rate: $9.51 per hour machine labor
Vines per Acre 605
$8.23 per hour non-machine labor
9.0 Tons per acre Fresh

The grapevines are expected to begin yielding fruit in three years and be productive for an additional 22 years (25 year life of asset).

Therefore, expenses incurred in the first three years in establishment and cultural practices for the production of raisins represent a capital expense (See Uniform Capitalization). All other reoccurring expenses are current expenses. 

The cost studies like the one above are available for most crops, see Outside Services Informational Sources at the end of this chapter. Many farmers have not allocated overhead expenditures to plantings on their books and therefore these studies provide normal costs per acre that should be shared with and refined by the farmer for capitalization of preproductive costs. Any large changes recommended by the farmer should be accompanied by reasonable explanations and supporting documents. 

Uniform Capitalization

This area of income tax administration is for costs incurred after December 31, 1986. There is increasing case law in this area as it pertains to agricultural growers. Most of the following is editorializing on the statute and regulations. This is intended as only a brief overview of this complex law to administer in examinations of agricultural  growers.

Scope
This discussion does not include “growers” who raise animals, Christmas, ornamental, or other nursery trees or flowers, though they are subject to the rules of IRC § 263A for other crops or property produced. It also does not apply to growers of plants (food and fiber) required to capitalize cost into an ending inventory under statutes other than IRC § 263A.

General Discussion
This was part of the Tax Reform Act of 1986.  IRC § 263A is entitled “Capitalization and inclusion in inventory costs of certain expenses.” It requires certain taxpayers to capitalize not only direct labor and direct materials but also certain “allocable indirect  costs.”

Also, this statute can be looked upon as a “disallowance provision” because IRC § 263A(a) stated, in part, “Nondeductibility of certain direct and indirect costs.”

The Accounting Concept of “Cost”
Cost is the amount of cash or equivalent given to acquire property or a service. The cost of properties or services acquired and on hand at any particular time represents assets. Such costs may also be referred to as “unexpired costs.” As the assets are sold or consumed, they become “expired costs” (or “expenses”).

Self Constructed Assets
An asset is any physical thing (tangible) or right (intangible) that has a monetary value.

A manufacturer builds a machine that produces the end product and it takes him three years to build this machine. How should the “stream of costs” that occurs over these three years be handled? This “stream” would include the entrepreneurial management, general labor cost, land, cost of materials, plant use, tools, etc., the capital (use of money) cost, all to construct this machine.

Generally Accepted Accounting Principles, GAAP,  would require that these costs be collected or bundled together as “unexpired costs.” When the machine begins to produce the end product, depreciation of these costs should begin. There would be an attempt to match the recognized outflow of cost with the recognized inflow of income that the machine generates.

Application to Agricultural Growers
These are divided into two groups:

1. Annual Planters - for these growers the general farm cycle is as follows:
   

   The farmer starts with bare land, prepares it, plants seeds, waters, fertilizes, protects, nurtures, harvests the end product, removes or plows under waste and returns to bare land.

   Examples are many: tomatoes, onions, peppers, melons, cotton, corn, wheat, etc. These “annual planters,” because their preproductive period is less than two years, are not subject to IRC § 263A.

2. Trees and Vines (Self-Constructed Farm Assets)

These farmers hold the land, plan its development, prepare it for planting, hire the labor to plant the young seedlings, nurture them with water, sprays, stakes, etc..  It may take over three years to develop these assets that produce the agricultural commodity.

1. Crops Subject to IRC § 263A

   The IRS has identified the following crops which have a nationwide weighted average preproductive period in excess of two years: almonds, apples, apricots, avocados, blueberries, blackberries, cherries, chestnuts, coffee beans, currants, dates, figs, grapefruit, grapes, guavas, kiwifruit, kumquats, lemons, limes, macadamia nuts, mangoes, nectarines, olives, oranges, papayas, peaches, pears, pecans, persimmons, pistachio nuts, plums, pomegranates, prunes, raspberries, tangelos, tangerines, tangors, and walnuts.  Notice 2000-45, 2000-2 C.B. 256.

   For purposes of determining whether a plant has a preproductive period in excess of two years, the preproductive period of plants grown in commercial quantities in the United States is based on a nationwide weighted average and not on the experience of the individual farmer. See example 4 of Treas. Reg. § 1.263A-4(b)(2)(i)(D), where a farmer produced in marketable quantities in less than 2 years, but was still required to capitalize the preproductive expenses.

2. Costs Subject to IRC § 263A

   Costs typically required to be capitalized under IRC § 263A include the acquisition costs of the seed, seedling, or plant, and the costs of planting,  cultivating, maintaining, or developing such plant during the preproductive period. These costs include, but are not limited to, management, irrigation, pruning, soil and water conservation (including costs that the taxpayer has elected to deduct under section 175), fertilizing (including costs that the taxpayer has elected to deduct under section 180), frost protection, spraying, harvesting, storage and handling, upkeep, electricity, tax depreciation and repairs on buildings and equipment used in raising the plants, farm overhead, taxes (except state and Federal income taxes) and interest required to be capitalized under IRC § 263A(f).  Treas. Reg. § 1.263A-4(b)(1)(i).

3. Defined “Preproductive Period”

   The statute is silent as to the beginning of the preproductive period. “In general, for purposes of this section [IRC § 263A], the term ‘preproductive period’ means—(i) in the case of a plant which will have more than 1 crop or yield, the period before the 1st marketable crop or yield from such plant...”  IRC § 263A(e)(3)

   “The actual preproductive period of a plant begins when the taxpayer first incurs costs that directly benefit or are incurred by reason of the plant. Generally, this occurs when the taxpayer plants the seed or plant.”  Treas. Reg. § 1.263A-4(b)(2)(i)(C)(1).

4. Defined “marketable quantities”

   “In the case of a plant that will have more that one crop or yield, the actual preproductive period ends when the plant first becomes productive in marketable quantities.” Treas. Reg. § 1.263A-4(b)(2)(i)(C)(2)(i).

   Plants that will have more than one crop or yield become productive in marketable quantities when the yield is deemed to be more than a de minimis portion of the estimated full production amount and that should be in combination with a net profit that reasonably contributes to the overhead costs of those plants. Treas. Reg. § 1.263A-4(b)(2)(i)(C)(2)(ii).

   Research Technical Advice Memorandums (TAM), etc. for discussions of “marketable quantities”.  Also, Pelaez and Sons, Inc. v. Commissioner, 114 T.C. 473 (2000), aff’d, 253 F.3d 711 (11th Cir. 2001).

Electing Out of the IRC § 263A Rules
Almond and citrus tree growers can not elect out of capitalizing preproductive expenses for the initial 4 years. IRC § 263A(d)(3)(C)

Other tree and vine farmers can elect out of the Uniform Capitalization rules in the first year the farmer has § 263A costs by not capitalizing the preproductive cost and applying special rules:

Section 1245 treatment upon disposition and required use of the Alternative Depreciation System (ADS) under IRC § 168(g)(2) for all assets used in farming and placed in service in the year preproductive costs begin.  The required use of ADS depreciation extends to related persons, which includes partnerships owned 50% or more by the electing taxpayer or members of the taxpayer’s family.  IRC § 263A(d)(3) & (e)

Section 263A Capitalization of Preproductive Cost with Respect to Orchards and Vineyards can be determined by answering the following questions: 1. Is the grower required to use the accrual method of accounting?  If Yes, then IRC § 263A applies.  If No, then: 2.  Did the grower replace plants lost in a casualty?  If Yes, then IRC § 263A does not apply. If No, then: 3. Is the Weighted Nationwide Average Preproductive Period, per Notice 2000-45, two years or less?  If Yes, then IRC § 263A does not apply.  If No, then: 4. Did the grower elect out of IRC § 263A by A.) Not Capitalizing the Preproductive Period Costs and B.) Applying the special rules of: a) IRC § 1245 treatment upon disposition of the property and b) Required use of the Alternative Depreciation System (ADS) for all assets used in farming and placed in service by the taxpayers or related entities upon commencement of incurring preproductive costs. If Yes, then IRC § 263A does not apply. If No, then: 5.  Did the grower incur/pay the Preproductive Period Costs of planting, cultivation, maintenance, or development of a citrus or almond grove? If Yes, then IRC § 263A applies.  If No, then IRC § 263A does not apply. 

Miscellaneous Deductions:
IRC 114, Extraterritorial Income Exclusion, ETI,  was added by P.L. 106-519, Sec 3(a), effective for foreign sales after 9-30-2000.  Farmers were allowed to claim a deduction in the Other Expenses category of the Sch F by completing Form 8873 with the allocated foreign sales income and expenses for the allowable deduction amount.  This was repealed by P.L. 108-357, Sec 101(d)-(f) with phase-out allowance of 80% in 2005 and 60% in 2006 of the otherwise-applicable pre-repeal ETI exclusion. 

IRC 199, Domestic Production Deduction, DPD, was enacted by P.L. 108-357, Sec 102(a), effective for tax years beginning after 12-31-2004. This deduction is phased-in based on the lower of qualified production activities income or taxable income. The phase-in percentages for tax years beginning in: 2005 or 2006 is 3%; 2007 thru 2009 is 6%; and 2010 and forward is 9%. The deduction is limited to no more than 50% of W-2 wages paid for the taxable year.

Audit Techniques

1. When inspecting returns always look for costs being deducted that appear to be excessive for the income reported. Determine if the costs are in the nature of establishing an orchard or vineyard.
2. If the farmer is currently deducting preproductive costs, check the detail depreciation schedule to verify that ADS life and straight line depreciation is being used on any farm assets placed into service during the preproductive period. If accelerated depreciation methods are used for the new assets, then there is an invalid election out of IRC § 263A. Also, if the farmer owns 50% or more of other farm entities, have they properly used ADS for all farm assets placed in service in a year of preproduction, within meaning of IRC § 263A(e)(2)(B)?
3. If there is an invalid election out, the examiner has two options: (1)  Change of Accounting Method to capitalize costs for the plants – in closed and open years that should not have been deducted – IRC § 481(a) adjustment or (2) Allow the election out of IRC § 263A and change the depreciation on the farm assets placed into service to be straight line and ADS lives. Calculation of any IRC § 481(b) limitations on the additional tax amount can be done by either the examiner or representative.  
4. When the books and records do not provide a means to separate operating costs of the mature plants from the preproductive plants, consider the use of  industry studies that give estimates of development costs per acre that can be reasonably applied to your grower.
5. The less than two years to producing in marketable quantities argument as a reason for not capitalizing does not apply to plants listed in Notice 2000-45.  How the marketable quantities amount was calculated should always be checked to supporting records. 
6. Take a tour of the farm and note the type of machinery present, young trees and vines, etc.  Ask questions about any of these and about the operations of the farm.