Rojas v. Commissioner

90 T.C. No. 73, 90 T.C. 1090, 1988 U.S. Tax Ct. LEXIS 73

Opinions

OPINION

WHALEN, Judge:*

Respondent determined deficiencies in the Federal income tax of petitioner Schwartz Farms, Inc., in the following amounts:

TYE Jan. 31— Deficiency

1975. $1,782

1977. 742,222

1978. 284,256

Total. 1,028,260

Respondent also determined that petitioners, Dorothy Schwartz Rojas and the estate of Charles R. Schwartz, deceased, were liable for such amount as transferees.¹

These cases were consolidated for trial, briefing, and opinion. After concessions, the only issue for decision is whether the tax-benefit rule requires Schwartz Farms, Inc., to report as income the amount which it deducted as expenses for materials and supplies which it used and consumed in connection with the cultivation of crops prior to its liquidation and the distribution of the crops to its shareholders.

All the facts have been stipulated. The stipulation of facts and attached exhibits are incorporated herein by this reference.²

Petitioner Dorothy Schwartz Rojas (Dorothy) resided in Ventura, California, at the time her petition in this case was filed. Dorothy is the surviving spouse of Charles R. Schwartz, deceased (decedent).

Petitioner Estate of Charles R. Schwartz, deceased, acting by and through Bank of America, National Trust & Savings Association, administrator (estate), is the successor in interest to the decedent, who died on April 6, 1976. The estate maintained offices at Fresno, California, at the time its petition in this case was filed.

Decedent’s will was admitted to probate in the Superior Court of California, for the County of Kings, on May 14, 1976. In accordance with the California Probate Code, Dorothy elected to subject her entire interest in the community property to administration in the estate. Consequently, the estate succeeded to the ownership of all the assets owned by decedent and Dorothy as their community property as of April 6, 1976. On June 12, 1984, the probate estate of decedent was distributed, approximately evenly between the Charles R. Schwartz Testamentary Trust (trust) and Dorothy. The estate is a transferee of petitioner Schwartz Farms, Inc. (corporation), and Dorothy and the trust are transferees of the estate. Respondent has not determined transferee liability against the trust.

The corporation was organized under the laws of California on April 8, 1954. The principal office of the corporation was in Fresno, California, at the time its petition in this case was filed. For Federal income tax purposes, the corporation reported income on the basis of a fiscal year ending January 31, and consistently used the cash basis method of accounting. At all relevant times the corporation was engaged in the business of farming row crops, primarily cotton, barley, wheat, and lettuce.

On October 1, 1976, the corporation adopted a plan of complete liquidation under section 337 of the Internal" Revenue Code of 1954. From the date of decedent’s death, April 6, 1976, until October 1, 1976, there were issued and outstanding 198,600 shares of the corporation’s common capital stock, which were owned, beneficially and of record, as follows:

Shareholder Number of shares

Charles R. Schwartz. 93,496

Dorothy Schwartz. 93,496

William Thornton. 4,104

Genevieve Thornton. 4,104

Charles R. Schwartz, Jr. 1,000

Diana J. Schneider. 800

Sylvia J. Thornton. 800

Claudia Thornton Whitener. 800

The shares which are listed as owned by Charles R. Schwartz and Dorothy Schwartz were the community property of decedent and Dorothy on April 6, 1976, and, pursuant to Dorothy’s election, became a part of the estate, along with all of their other community property.

The community property interest of Charles R. Schwartz in the corporation’s common stock was included in decedent’s gross estate for Federal estate tax purposes. On a timely filed estate tax return, the assets included in decedent’s Federal gross estate were valued as of the alternate valuation date.

Pursuant to the plan of liquidation, cash distributions were made to the following shareholders:

Shareholder Amount

William Thornton. $91,806.48

Genevieve Thornton. 91,806.48

Charles R. Schwartz, Jr. 22,370.00

Diana J. Thornton . 17,896.01

Sylvia J. Thornton . 17,896.01

Claudia Thornton Whitener. 17,896.01

259,670.99

On October 26, 1976, all of the corporation’s operating assets were distributed to the estate pursuant to the plan of liquidation. Such assets were assigned fair market values on October 26, 1976, as follows:

Description of item Fair market value

Crops

Cotton — lint total. $1,931,052

Cotton — seed. 81,956

Less reported by corporation. (94,621)

Less total harvest costs. (267,146)

Plus harvest cost by corporation . 4,500

Total cotton. 1,655,741

Wheat crop . 41,552

Barley. 271,006

Lettuce. 108,622

Total crops. 2,076,921

Canal stock. 67,350

Prepaid rent. 2,100

Unamortized lease costs. 234,200

Cotton allotment. 0

Land. 432,320

Buildings — net of depreciation. 261,226

Pipelines and sprinklers — net.. 86,391

Pumps and wells — net. 52,211

Domestic water system — net .. 3,214

Drainage system — net. 24,471

Machinery and equipment — net 68,627

Toted. 3,309,031

All the remaining assets of the corporation were thereafter distributed to the estate during 1977 and 1978, with a final distribution of $100 on January 31, 1979.³ Pursuant to the plan of liquidation, all the outstanding shares of the corporation were surrendered and canceled.

As noted above, among the assets distributed by the corporation to the estate on October 26, 1976, were the following crops: harvested barley, harvested wheat, heir-vested cotton (lint and cotton seed), harvested lettuce, unharvested fall lettuce, and unharvested cotton.⁴ The unharvested lettuce represented approximately 50 percent of the 1976 fall lettuce crop, and the unharvested cotton represented approximately 76 percent of the 1976 cotton crop.

On the corporation’s return for the taxable year ended January 31, 1977, the corporation deducted all the costs and expenses incurred in connection with the cultivation and harvesting of the crops that were distributed on October 26, 1976, pursuant to the plan of liquidation. The total expenses thus deducted for each crop and the portion thereof which respondent seeks to include in income are as follows:

Expenses deducted Income adjustment⁵

Cotton $739,479 $692,379

Wheat and barley 333,564 157,909

Lettuce 59,616 59,616

Total 1,132,659 909,904

All the crop costs deducted were incurred in the ordinary course of the corporation’s business and represented expenditures for all costs incurred up to the liquidation date in connection with the growing of the crops, including seed, fertilizer, water, labor, equipment rent and maintenance, pesticide, supervision, and general administrative overhead. All materials purchased in connection with each crop were used and applied in cultural practices prior to October 26, 1976, and no portion thereof was inventoried or distributed to the shareholders in liquidation.

After the liquidation distribution, the estate continued to use the operating assets which it received in the conduct of a farming operation similar to the operation conducted by the corporation before the distribution. The estate sold all of the crops that were distributed to it in liquidation in the ordinary course of such business.

As a result of the complete liquidation of the corporation, the estate and Dorothy realized a long-term capital gain of $681,514, measured by the difference between the fair market value of all the assets (net of liabilities) distributed to them in liquidation and the income tax basis of the corporation’s stock in their hands.

Each of the assets received by the estate in the October 26, 1976, liquidation distribution had an income tax basis in the hands of the estate equal to the fair market value of each such asset determined as of the date of distribution pursuant to section 334(a).⁶

The notice of deficiency issued to the corporation determined that additional income should be included in the corporation’s return for the year ending January 31, 1977, on the ground “that the accrual method of accounting clearly reflects your income.” As an alternative theory, respondent determined that, “if it is found that the accrual method of accounting does not clearly reflect income for the tax year ending January 31, 1977,” then assignment of income principles required $628,217 of the crop income to be included in the corporation’s income for the tax year ending January 31, 1978.

In its second amendment to answer, respondent abandoned both the accrual method of accounting theory and the assignment of income theory and the parties have stipulated as follows:

The parties agree that the sole issue for decision by the Court is whether, under the tax benefit rule as set forth by the United States Supreme Court in Hillsborough [sic] National Bank v. Commissioner and United States v. Bliss Dairy, Inc., 460 U.S. 370 (1983), Schwartz Farms, Inc. is required to restore to income crop costs in the amount of $909,904.00 * * *

In view of the fact that respondent abandoned application of the accrual method of accounting and application of the assignment of income doctrine in this case, we have not considered either such theory and limit our opinion to the application of the tax-benefit rule.⁷

The tax-benefit rule is a judicially created doctrine, embodied in part in section 111. It operates to rectify certain distortions which would be brought about by the inflexible application of the annual accounting system used in reporting Federal income taxes. Hillsboro National Bank v. Commissioner and United States v. Bliss Dairy, Inc., 460 U.S. 370, 377 (1983) (hereafter Bliss Dairy). The application of the tax-benefit rule is frequently illustrated by reference to collection of a debt which had been deducted in a prior tax year under section 166(a) as a bad debt. 460 U.S. at 377. In such case, the so-called “inclusionary component” of the tax-benefit rule requires the taxpayer to recognize the repayment as income in the year of recovery. Otherwise, the repayment, a return of capital, would not be taxable and the Government might be foreclosed from recouping the tax-benefit attributable to the prior deduction. Under the so-called “exclusionary component,” the amount included in the year of recovery is limited to the amount of the tax-benefit received from the deduction in the prior year. See sec. 111(a).

The above illustrates the application of the tax-benefit rule where the taxpayer has made an actual recovery of the amount previously deducted. As first formulated, such a recovery was required for application of the rule. See, e.g., Nash v. United States, 398 U.S. 1 (1970). Under the Supreme Court’s formulation of the rule in Bliss Dairy, however, the purpose of the rule is not simply to tax “recoveries” but is to approximate the results produced by a tax system based on transactional rather than annual accounting, i.e., “to achieve rough transactional parity in tax.” United States v. Bliss Dairy, Inc., supra at 381-383. The tax-benefit rule will be applied when it appears that a later unforeseen event is “fundamentally inconsistent with the premise on which the deduction was initially based,” in the sense that the deduction would have been foreclosed if the event had occurred in the same taxable year. 460 U.S. at 383-384. The Court made it clear, however, that not every unforeseen event will require application of the tax-benefit rule. 460 U.S. at 383.

The Supreme Court refused to adopt a blanket rule for application of the tax-benefit rule but stated that it must be applied on a “case-by-case basis.” It charged lower courts with the obligation of considering “the facts and circumstances of each case in the light of the purpose and function of the provisions granting the deductions.” United States v. Bliss Dairy, Inc., supra at 385-386.

The taxpayer in Bliss Dairy was a closely held corporation engaged in the business of operating a dairy. It reported income on the cash method of accounting and properly deducted certain cattle feed which it purchased for use in its business during its fiscal year ending June 30, 1973. The deduction was based upon section 162(a). After the beginning of its next fiscal year, the corporation adopted a plan of liquidation under sections 333 and 336 and, thereafter, distributed to its shareholders all of its assets, including the cattle feed then on hand. After the liquidation, the shareholders continued to operate the dairy business in noncorporate form.

The Supreme Court began its analysis of the tax-benefit rule in Bliss Dairy by examining the purpose and function of section 162(a) under which the cost of the unused feed was deducted, and it noted as follows:

Section 162(a) permits a deduction for the “ordinary and necessary expenses” of carrying on a trade or business. The deduction is predicated on the consumption of the asset in the trade or business. See Treas. Reg. section 1.162-3, 26 CFR section 1.162-3 (1982) (“Taxpayers * * * should include in expenses the charges for materials and supplies only in the amount that they are actually consumed and used in operation in the taxable year * * * ”) [United States v. Bliss Dairy, Inc., supra, at 395. Emphasis in original.]

The Court then reasoned that the distribution of the grain to the shareholders in liquidation of Bliss Dairy, Inc., was a nonbusiness use of the grain, analogous to personal consumption, explicitly made nondeductible by section 262. The Court held that the liquidation was “fundamentally inconsistent” with the earlier deduction of the cost of the grain because it converted the grain to a nonbusiness use and, thus, frustrated consumption of the grain in the business, the premise on which the deduction was allowed. United States v. Bliss Dairy, Inc., supra at 395-396.

Like Bliss Dairy, the deductions at issue in this case were taken by the corporation prior to its liquidation and there was no subsequent recovery of those deductions. Like Bliss Dairy, the operating assets of the corporation were distributed to its shareholders in the liquidation, and they continued to operate the business in noncorporate form. Petitioners do not challenge the conclusion of the Supreme Court that a liquidating distribution of an asset is a conversion of that asset to a nonbusiness use nor do they challenge the Court’s holding that the nonrecognition language of section 336 does not permit a liquidating corporation to avoid the tax-benefit rule. Like Bliss Dairy, the deductions here were taken under section 162. Therefore, the issue in this case is the same as the issue framed by the Supreme Court in Bliss Dairy, namely, whether the distribution of the operating assets of the corporation, a nonbusiness use, is “fundamentally inconsistent” with the “purpose and function” of section 162, under which the deductions at issue were taken.

The liquidation in Bliss Dairy took place in a taxable year after the year in which the deductions were taken, whereas the liquidation in the instant case took place within the same taxable year. Petitioners seize upon such difference and argue that the tax-benefit rule is inapplicable where the inconsistent event takes place within the same taxable year as the deduction. We are constrained to reject this argument under Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971), cert. denied 404 U.S. 940 (1971). The Ninth Circuit, the court to which an appeal of this case lies, has held — in a case cited with approval in United States v. Bliss Dairy, Inc., supra at 401 — that tax-benefit principles apply in such a ease with even greater force, even though use of the “tax-benefit rule” label may be inappropriate. Spitalny v. United States, 430 F.2d 195, 198 (9th Cir. 1970). The court also stated in Spitalny that it is of “no consequence” whether the adjustment takes the form of a disallowance of an item of expense or a restoration to income. 430 F.2d at 198.⁸

The only significant difference between this case and Bliss Dairy is the fact that the parties have stipulated, and we have found, that the cost of the materials and services at issue were incurred in the ordinary course of the corporation’s farm business and that all of the materials purchased were “used and applied in cultured practices” prior to the liquidation and no portion of such materials was inventoried or distributed to the shareholders in liquidation. In Bliss Dairy, on the other hand, the deductions at issue represented the cost of unconsumed cattle feed which was distributed to the shareholders.

Petitioners note that the crop costs at issue consist of expenditures for seed, fertilizer, water, labor, equipment rent and maintenance, pesticide, supervision, and general and administrative overhead. They emphasize that all such materials and services were used and consumed in the ordinary course of the corporation’s farming business prior to the liquidation and that no such materials and services were on hand at the time of the liquidation or distributed to the shareholders. In petitioners’ view, therefore, such materials and services are similar to the cattle feed which had been consumed by the dairy cows in Bliss Dairy and the fundamental inconsistency on which the Court’s decision in that case was based is not present here, inasmuch as those assets were consumed in the business and not converted to a nonbusiness use. Petitioners assert that Bliss Dairy requires us to reach a result opposite to the one in that case.

Respondent, on the other hand, also relies on Bliss Dairy but concludes that the Court’s decision requires application of the tax-benefit rule here. In respondent’s view, the Supreme Court held that a deduction under section 162 “presumes that an expense is necessary to produce income * * * [and] should no income result due to an intervening personal use of the asset,” there arises a fundamental inconsistency which requires application of the tax-benefit rule. Respondent does not deny that the materials and services at issue in this case were consumed but argues that “physical consumption of an asset should not be confused with business consumption as contemplated by section 162(a).”

Respondent, therefore, asks us to go beyond Bliss Dairy and to hold that deductions for services (such as labor, equipment rent and maintenance, supervision, and general and administrative overhead), all of which had been expended prior to the liquidation, and deductions for materials (such as feed, fertilizer, water, labor, and pesticide), none of which were on hand at the time of a liquidation, must be “cancelled out” under the tax-benefit rule. In respondent’s view, this result is required because such materials and services were expended to produce crops which were not sold but were distributed in liquidation to the corporation’s shareholders. Respondent argues that deductions under section 162 for such materials and services Eire predicated on the sale of the product produced and not just on the consumption of materieils and services in the taxpayer’s business.

In support of its position, respondent asserts that the Court in Bliss Dairy determined that deductions under section 162 are predicated on sale of the product produced from such expenses and the production of income. We disagree. In Bliss Dairy, the Court stated that deductions under section 162 are “predicated on the consumption of the asset in the trade or business.” 460 U.S. at 395. The regulation, section 1.162-3, Income Tax Regs., on which the Supreme Court relied, states as follows:

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

To “consume” an asset means nothing more than to use it up. Webster’s Third New International Dictionary 490 (1986). If an asset is used up in furthering the taxpayer’s trade or business, as was the case with the materials and services at issue, then the predicate for deducting the cost of the asset under section 162 would seem to be fulfilled.⁹ Significantly, the Supreme Court, in examining the “purpose and function” of deductions under section 162 in terms of the facts in Bliss Dairy, makes no mention of sedes of milk to be produced from the taxpayer’s dairy cows.

We are not at liberty to speculate about the meaning of the words “actually consumed” emd “used” as applied to seed, fertilizer, and other farm supplies. Congress made the meaning of such words clear in the legislative history of section 464(a), which was originally enacted in 1976. That provision states as follows:

In the case of any farming syndicate (as defined in subsection (c)), a deduction (otherwise allowable under this chapter) for amounts paid for feed, seed, fertilizer, or other similar farm supplies shall only be allowed for the taxable year in which such feed, seed, fertilizer, or other supplies are actually used or consumed, or, if later, in the taxable year for which allowable as .a deduction (determined without regard to this section). [Emphasis supplied.]

A farm business is normally entitled to use the cash method of accounting and to deduct seed, fertilizer, and other farm supplies under section 162 at the time such supplies are purchased. Section 464(a) provides that a “farming syndicate” which Congress considered to be abusive is entitled to deduct the cost of such materials no earlier than the taxable year in which they are “actually used or consumed.” The legislative history of section 464(a) clarifies the intended meaning of those words as follows:

This provision prevents a farm syndicate from obtaining current deductions for prepaid feed, seed, fertilizer, etc., except in situations where the feed, seed, fertilizer, or other supplies are on hand at the close of the taxable year solely because the consumption of such items during the taxable year was prevented on account of fire, storm, flood, or other casualty, or on account of disease or drought. [S. Rept. 94-938, at 61 (1976), 1976-3 C.B. (Vol. 3) 99. Emphasis supplied.]

In other words, if such crop materials are not “on hand” at the end of the taxable year, then they have been consumed in the farm business and may be deducted by a “farming syndicate.” Even in the case of a farming syndicate, therefore, Congress stated its intention to allow farm supplies to be deducted when they are no longer “on hand” and, in allowing such deductions, Congress made no reference to the sale of the crops produced.

Section 1.162-12, Income Tax Regs., dealing with the deductibility of “expenses of farmers,” is consistent with the view that farm materials and services are deductible under section 162 when used up in the farm business without regard to any sale of the crops produced. In the case of a farm operated for profit, that regulation provides as follows:

A farmer who operates a farm for profit is entitled to deduct from gross income as necessary expenses all amounts actually expended in the carrying on of the business of farming. [Emphasis supplied.]

Once again, there is nothing, either explicit or by necessary implication, in this provision to suggest that the deduction of crop expenses is predicated on eventual sale of the crop. In fact, to the contrary, the general rule under that regulation is that crop expenses are to be deducted as the amounts are expended. It is only “with the consent of the Commissioner” that a farmer may adopt the so-called “crop method,” which allows deductions to be taken in the taxable year in which the gross income from the crop has been realized. Sec. 1.162-12, Income Tax Regs.

The issue here is more than a semantic difference between the respondent and petitioners over the meaning of the word “consumed.” Respondent’s application of the tax-benefit rule in this case is a significant expansion of the rule and, in our view, goes far beyond its intended scope. Under respondent’s formulation, every business deduction under section 162 would be “cancelled out” if an unforeseen event, not just a corporate liquidation, frustrated the sale of any products which would otherwise have been completed and sold. In this case, it is particularly significant that respondent seeks to recapture deductions for general and administrative overhead and equipment maintenance costs. Under the respondent’s formulation of the rule, therefore, every taxpayer, regardless of its method of accounting, would be required to precisely allocate and recapture all of its business deductions attributable to the production of products every time an unforeseen event frustrated then-sale. The respondent’s formulation goes beyond “rough transactional parity.” Such an expansive recapture rule is not contemplated by either the holding of Bliss Dairy, which is limited to recapture of the deduction for the cost of assets which were themselves distributed in the liquidation, or by the spirit of the case, which referred to the tax-benefit rule as a “limited rule.” 460 U.S. at 389. Respondent has cited no authority which suggests that we should go beyond the holding of the Supreme Court in Bliss Dairy.

Respondent relies on our decision in Byrd, Transferee v. Commissioner, 87 T.C. 830 (1986), affd. without published opinion 829 F.2d 1119 (4th Cir. 1987). That case involved the deductibility of the cost of an “inventory” of young plants which had been purchased for resale but which were on hand at the time of the liquidation. In that case, resale was the act of consuming or using the young plants in the taxpayer’s trade or business. We held that the liquidation transaction was inconsistent with the prior deduction of the cost of such unsold plants. Our opinion states, “We * * * view Bliss Dairy as controlling for our purposes.” 87 T.C. at 837. The “fundamental inconsistency” which we found in that case is as follows:

Petitioners deducted the cost of young plants purchased for sale in their business after the plants had grown to mature size. Instead of selling the plants in the ordinary course of their trade or business and realizing income to offset the cost of production, petitioners distributed the plants to its shareholder in liquidation. [87 T.C. at 838; emphasis supplied.]

The young plants at issue in Byrd, like the feed at issue in Bliss Dairy, were not consumed in the trade or business but were on hand and distributed in the liquidation.

Our decision in Tennessee Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440 (1975), affd. 582 F.2d 378 (6th Cir. 1978), cert. denied 440 U.S. 909 (1979), involved a corporation which engaged in the motor freight transportation. business. Prior to its liquidation, the taxpayer purchased tires and tubes to be mounted on equipment already in use. The cost of the tires and tubes was charged to expense, rather than capitalized, on the assumption that the average useful life of the tires and tubes was one year or less. We applied the tax-benefit rule on the theory that “Certain of the tires and tubes whose cost [the taxpayer] expensed were not fully consumed in its operations * * * [but] were distributed by [the taxpayer] in liquidation when a substantial portion of their useful life had not been exhausted.” 65 T.C. at 446. In applying the tax-benefit rule in that case, we required the taxpayer to include in gross income, not the original cost of the tires and tubes, but thé portion of such cost allocable to their remaining useful life. It was that portion which had not been consumed in the taxpayer’s operations and, therefore, only that portion which was inconsistent with a deduction under section 162.

In Spitalny v. United States, 430 F.2d 195 (9th Cir. 1970), the Ninth Circuit, to which this case is appealable, applied the tax-benefit rule in connection with the liquidation, under section 337, of a cattle feeding business. Unlike dairy cows, such as those involved in Bliss Dairy, which are fed and maintained in order to produce milk for sale, a cattle feeding business purchases cattle to be fattened and then resold at a profit. In Spitalny, the court applied the tax-benefit rule to “cancel out” the taxpayer’s deductions with respect to the feed and supplies sold in connection with the section 337 liquidation. The court stated as follows:

We agree with the Government that distortion of income results from appellees’ accounting method. The expense deduction as permitted by regulation is intended to reflect the cost of feed actually consumed during the taxable year and to accomplish over a period of years roughly the same result as would have been had through use of the inventory method, but by a simpler form of accounting. [430 F.2d at 197; emphasis in original.]

Once again, the tax-benefit rule was applied only to the expensed assets which were on hand and not to materials and supplies which had been consumed.

Similarly, in Estate of Munter v. Commissioner, 63 T.C. 663 (1975), we applied the tax-benefit rule in the case of a laundry business which also engaged in the business of renting linen items and garments. That case involved an accrual method taxpayer which inventoried its cost of linen supplies and other rental items as they were purchased. When a rental item was placed in service by delivery to a customer, the cost of the item was removed from the inventory account and charged to expense. Accordingly, when the corporation adopted a plan of liquidation under section 337 and sold its assets, there were substantial linen items which had been fully deducted but which had not been actually consumed in the business.

In Gorton v. Commissioner, T.C. Memo. 1985-45, we applied the tax-benefit rule to the liquidation of a chicken and egg ranch which distributed an inventory of materials to a trust which continued to operate the business for the benefit of the former shareholders. In applying the tax-benefit rule, we noted that the materials had previously been deducted under section 162 and that “the corporation would have received the benefit of the deduction without using these items in its business, as intended by section 162(a).” We find nothing in Gorton v. Commissioner to suggest that deductions under section 162 are predicated on more than the use and consumption of the asset in the taxpayer’s business.

Lastly, in Ballou Construction Co. v. United States, 611 F. Supp. 375 (D. Kan. 1985), the taxpayer was engaged in the business of extracting, processing, and selling sand and gravel from sand and gravel pits before it liquidated and distributed its assets to a new corporation which claimed a stepped-up basis for the assets under section 334(b)(2). The case involved the application of the tax-benefit rule to costs which had been incurred and deducted by the taxpayer for removal of overburden, a step necessary before sand and gravel can be removed from a sand and gravel pit. The parties stipulated that removal of the overburden enhanced the value of the “sand deposit in place,” one of the assets distributed in the liquidation, by $20,000.¹⁰ The court applied the tax-benefit rule to increase the taxpayer’s income by the same amount.

It appears that the taxpayer in Ballou Construction did not raise the issue before us here, i.e., whether the tax-benefit rule can be applied to cancel out business deductions for materials and services which are consumed in the business before a liquidating distribution. In fact, the court treated the “sand deposit in place” as the equivalent of the unconsumed feed in Bliss Dairy. The court stated as follows:

The premise of a deduction under section 162(a) is that an expensed asset will be consumed by the taxpayer in his trade or business. Salina Sand’s later distribution was an inconsistent event with the deduction for two reasons. First, the taxpayer who sells rather than consumes an expensed asset will lose the deduction because the full amount of the proceeds must be recognized. Second, Salina Sand’s distribution of the “Sand Deposit in Place” to its shareholder “turns the expensed asset to the analog of personal consumption” and thus the assumption underlying the original deduction is proven invalid. [611 F. Supp. at 378.]

It is clear that the court simply applied the logic of the Supreme Court in Bliss Dairy to the facts before it on the assumption that the deducted costs were directly attributable to the sand deposit in place, an asset which had not been consumed. The court was not called upon to consider the issue in this case. Moreover, the language quoted above provides no support for respondent’s position in this case that deductions under section 162(a) are premised on the sale of the product produced, rather than on consumption of the expensed asset in the taxpayer’s business.

Historically, farmers have had the option of using the cash method of accounting without the need to accumulate inventories or to use the inventory method of accounting. Sec. 39.22(c)-6(a), Regs. 118; sec. 1.471-6(a), Income Tax Regs.; sec. 1.61-4, Income Tax Regs.; Hi-Plains Enterprises, Inc. v. Commissioner, 60 T.C. 158 (1973), affd. 496 F.2d 520 (10th Cir. 1974). A cursory review of certain farm tax provisions shows that Congress intended to provide farmers with “more liberal accounting rules than those generally applicable in the case of other types of business activities.” H. Rept. 91-413 (Part 1), at 62 (1969), 1969-3 C.B. 240; S. Rept. 94-938, at 52 (1976), 1976-3 C.B. (Vol. 3) 90. Congress also recognized that the special farm accounting rules required no matching of deductions and income and, therefore, contemplated that distortions would result. For example, in connection with its passage of section 207(a) of the Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1536, adding section 464 to the Code, the Senate Report, S. Rept. 94-938, supra at 53-54, 1976-3 C.B. (Vol. 3) at 91-92, states as follows:

Farm investments offer an opportunity to defer taxes on nonfarm income where investors can take advantage of the special farm tax rules to deduct farm expenses in a year or years prior to the years when the revenue associated with such expenses is earned. This type of deferral can occur regardless of whether the proceeds from the later sale of the underlying products are taxed at ordinary income or capital gain rates. Generally, in farming operations tax losses can be shown in early years of an investment because of (1) the opportunity to deduct, when paid, costs which in nonfarm businesses would be inventoried and deducted in a later year, (2) the ability to deduct, when paid, costs which should properly be capitalized, and (3) the ability to claim depreciation deductions which exceed straight-line depreciation.

These tax losses may offset income from a taxpayer’s other nonfarm occupations or investments on which he would otherwise have to pay tax currently. When the income which is related to these deductions is reported, it will not be reduced by the amount of the deductions properly attributable to it (and will thus be greater in net amount than it otherwise would be). This lack of matching results in deferral, of taxes from the years when the initial deductions were taken. If the related farm income is eventually realized as capital gain (as it may be where breeding animals or orchards are sold), conversion of ordinary income (against which the expenses were deducted) into capital gain may also result. Even without the possibility of conversion, however, the tax advantages of deferral alone are frequently sufficient to motivate many high-income taxpayers to engage in certain types of farming activities.

Through the years, Congress has imposed some limits on the use of the special farm accounting provisions in the case of farm syndicates and the like but, as recognized during passage of the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, “Most farmers use the cash method of accounting, and therefore do not maintain inventories or capitalize preproductive period costs (i.e., costs incurred prior to the time a plant or animal becomes productive).” H. Rept. 99-841 (Conf.), at 11-112 (1986), 1986-3 C.B. (Vol. 4) 112.

It would appear, therefore, that Congress intended to allow farm businesses, like Schwartz Farms, Inc., to deduct crop costs without the necessity of matching such costs against the income which would be realized from the sale of the crops themselves. Nevertheless, respondent’s position in this case is that the crop costs which are otherwise deductible under section 162 at the time paid should be “inventoried” and recaptured in the event there is no business sale of the crop produced. We agree that Bliss Dairy requires recapture with respect to any farm materials on hand at the time of a liquidation, but we fail to see that the tax-benefit rule requires the cost of materials and supplies consumed in the farm business to be recaptured in this case, in view of the clear legislative intent to allow most farmers to dispense with the need to accumulate inventories. Cf. Rev. Rui. 85-186, 1985-2 C.B. 84, where respondent recognized that application of the tax-benefit rule to deductions for research and experimentation under section 174(a) was inappropriate in view of clear legislative intent to relieve taxpayers of the obligation to allocate costs between amounts currently deductible and amounts required to be capitalized.

Decisions will be entered under Rule 155.

Reviewed by the Court.

Sterrett, Whitaker, KDrner, Cohen, Clapp, Swift, Wright, Williams, and Wells, JJ., agree with the majority opinion. GERBER, J. did not participate in the consideration of this opinion.

Footnotes

*

By order of the Chief Judge, these cases were reassigned to Judge Whalen for decision and opinion.

1

Although the notice of deficiency relates to the 3 taxable years of Schwartz Farms, Inc., set out above, the notices of transferee liability relate only to the year ending Jan. 31, 1977. Neither party has provided any explanation for, or raised any question concerning, this apparent discrepancy.

2

Petitioners object, on the grounds of relevancy, to par. 10, 11, and 12, and the last sentence of par. 5 of the stipulation. We disagree and include them in our findings of fact.

3

No issue has been raised by the parties about the fact that the final distribution took place more than 12 months after the date on which the corporation adopted the plan of complete liquidation under sec. 337.

4

No suggestion has been made-by the parties that sec. 268 (“sale of land with unharvested crop”) is applicable in this case.

5

In calculating the amount of the adjustment, the parties agreed in the stipulation of facts to reduce the total expenses with respect to each crop by the same ratio which crop sales reported by the corporation on its return bears to the total proceeds from sales of the crops.

6

Unless otherwise indicated, all section references are to the Internal Revenue Code as in effect during the years in issue. All Rule references are to the Tax Court Rules of Practice and Procedure.

Sec. 334(a) provides:

SEC. 334(a). General Rule. — If property is received in a distribution in partial or complete liquidation (other than a distribution to which section 333 applies), and if gain or loss is recognized on receipt of such property, then the basis of the property in the hands of the distributee shall be the fair market value of such property at the time of the distribution.

7

We note that petitioners object to allegations by respondent in par. 8(u) of his second amendment to answer that:

“No valid business reason existed to distribute the crops at this time as all the crops would have been harvested within 30 days. The reason for this distribution was to avoid the taxation on the proceeds from the crops.”

Respondent has the burden of proving any new matter raised in his answer. Rule 142(a). Petitioners argue that respondent has failed his burden of proof on this issue. Respondent maintains that the timing of the distribution indicates that the corporation had no business reason other than tax avoidance for the distribution in this case.

However, neither party has shown, and we do not find, that the existence of a valid business reason or the lack thereof is relevant to the issue in this case, i.e., whether the tax-benefit rule requires that the corporation include in its income previously deducted expenses. The tax-benefit rule ordinarily applies to require the inclusion in income when events occur which are fundamentally inconsistent with an earlier deduction or when there has been a recovery of a previously deducted item. Because the existence or absence of a valid business reason for the liquidation is irrelevant to the determination of whether there has been an inconsistent event or a recovery in this case, we decline to find facts relating to the existence of a valid business reason for the liquidation.

8

The Supreme Court described the tax-benefit rule as “cancelling out” an earlier deduction and, presumably, agrees with the Ninth Circuit that it is of no consequence whether the cancelling out takes place by way of a reduction of the deduction or an increase in income. Hillsboro National Bank v. Commissioner and United States v. Bliss Dairy, Inc., 460 U.S. 370, 383 (1983).

9

Judge Nims, in his dissent, states that “the phrase ‘actually consumed and used in operation in the taxable year’ includes both consumption and sale in the ordinary course of the taxpayer’s business.” (See p. 1110). Curiously, however, the regulation quoted above does not say “consumed and sold,” as it easily could have, nor is that concept implicit therein. What the regulation does say is “actually consumed and used.” An asset must be both used and consumed in the business before its cost is deductible under sec. 162. If the asset is used in the business but not consumed, a full deduction of its cost is not appropriate. See, e.g., Tennessee Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440 (1975), affd. 582 F.2d 378 (6th Cir. 1978), cert. denied 440 U.S. 909 (1979).

10

It is not clear what relationship, if any, such amount bore to the costs of removal of the overburden which had been deducted.