The U.S. Tax Court today issued an opinion holding that the tax benefit rule does not require the recapture of deductions for farm inputs claimed by the taxpayer-husband on his 2010 Schedule F upon his death in 2011, and the taxpayer-widow’s acquisition by inheritance of the farm inputs and her subsequent use of them in her separate farming operations.
The case is: Estate of Backemeyer v. Commissioner, 147 T.C. No. 17 (December 8, 2016). Read the Tax Court’s opinion [PDF 129 KB]
The taxpayers were husband and wife, and he was a sole proprietor farmer. The taxpayer-husband purchased certain “farm inputs”—tangible personal property used in agricultural production such as seed, fertilizer, herbicides, and fuel, some of which had been obtained from farmers’ cooperatives—in 2010 with the intention of using them to cultivate crops the following year. As a cash-method taxpayer, the taxpayer deducted his expenditures on the inputs under section 162 for that same tax year.
The taxpayer-husband then died in March 2011, not having used any of the purchased farm inputs. These inputs were subsequently transferred to his widow, who began her own farming business as sole proprietor upon his death. She used all the farm inputs in 2011 to grow crops that were then sold in 2011 and 2012. She then deducted for tax year 2011, an amount equal to the value of the farm inputs inherited from her late husband.
On audit, the IRS determined an income tax deficiency for 2011 of over $78,000 and assessed a penalty under section 6662 of almost $16,000. The IRS explained that when the taxpayer-husband died not having used the farm inputs in his sole proprietor farming operation, the farm inputs were converted to a nonbusiness use when they were distributed to a family trust. When the taxpayer-widow received the assets, she took them with a stepped-up basis and contributed them to her sole proprietor farming business. Therefore, upon his death, the farm inputs were converted from business to personal use, and the widow converted them back from personal to business use. According to the IRS, this entitled the taxpayer-widow to a deduction under section 162 but also required the taxpayer-husband to recognize income related to his conversion of the property from one use to another.
The Tax Court addressed and decided the following issues:
As the Tax Court noted, the IRS had conceded that the taxpayer-widow’s treatment of the farm inputs was correct: She received the assets with a stepped-up basis and contributed them to her sole proprietor farming business, entitling her to deduct the farm inputs in the amount of the stepped-up basis when those assets are used in her business. However, the IRS continued to assert that the tax benefit rule required the inclusion in the taxpayer-husband’s 2011 income the amount of the prepaid expenses for the farm inputs that he had deducted for 2010.
The Tax Court concluded that in evaluating the application of the tax benefit rule to the deduction under section 162 of farm input expenditures, the analysis to be applied was that mandated by the U.S. Supreme Court in Bliss Dairy, Inc. v. United States and the four-part test in Frederick v. Commissioner—that is, an amount must be included in gross income in the current year to the extent that (1) it was deducted in a prior year, (2) the deduction resulted in a tax benefit, (3) an event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and (4) a nonrecognition provision of the Code does not prevent inclusion in gross income.
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