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Cash Basis Farmers Allowed to Deduct All Costs!

Published on: 13:37PM Jul 31, 2015

The Tax Court released the Agro-Jal Farming Enterprises case yesterday and the court ruled that cash basis farmers are essentially allowed to deduct all costs related to the business of farming.  The taxpayer was a farmer in Santa Maria, California who grew various vegetables.  As part of the harvesting process, the crops would be placed directly into packaging materials such as plastic clamshells.  These packaging materials for financial statement purposes were tracked and if there were supplies on hand at the end of the year, the supplies were not deducted.  Rather, the deduction occurred when the supplies were used.

However, for income tax purposes, the taxpayer used the cash method of accounting and all supplies were deducted when purchased.  The Tax Court looked at two specific Code Sections (464 and 162).  464 deals with a farm syndicate not being able to deduct "feed, seed, fertilizer, or other similar farm supplies".  The taxpayer had argued that packaging supplies were part of the "other similar farm supplies" and the Tax Court ruled that they were not, so it moved onto the question under Section 162.

The whole discussion of the case revolved around the following part of the Regulations:

"Taxpayers carrying materials and supplies on hand should include in expenses the charges for material 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 material and supplies have not been deducted in determining the net income or loss or taxable income for any previous year."

The IRS argued that these supplies could only be deducted when actually used or consumed.  The taxpayer argued that provision only applied if the taxpayer had not already deducted the supplies in any previous year (which applied in this case).  The Tax Court ruled in favor of the taxpayer on this matter.  Both the taxpayer and the IRS agreed that all of these supplies would be consumed within one year of purchase (if longer, then those supplies would not be allowed as a deduction as a qualified prepaid expense).

The Tax Court also went into the definition of materials and supplies "on hand".  The above regulation applies to materials and supplies "on hand" which the court ruled applied only to material actually in the hands of the taxpayer or are in transit to the taxpayer.  If the supplies have not yet been manufactured, then this Section does not apply and under the normal prepaid farm expenses Section, the deduction is fully allowed.

All-in-all, this was a firm victory for the taxpayer and farmers in general.  One interesting part of the decision was on page 23 dealing with an allowed deduction for farmers using supplies that were not year paid for.  Per their example, if a farmer ordered and consumed $100 of supplies in year X1, but did not pay for the supplies until year X2, the Court seemed to indicate that this deduction MIGHT be allowed, although it also indicated that the IRS could argue that the taxpayer's accounting system in this case is distorting income.   This would be a rare case anyway.

This is just another case that bolsters the ability of farmers to deduct almost all farming costs in the year of payment for cash basis farmers.