*73 Decisions will be entered under Rule 155.
D and E are the transferees and former majority shareholders of S, a corporation that had been engaged in the business of farming row crops. S adopted a plan of complete liquidation and pursuant to that plan, distributed to its majority shareholders all its operating assets, including certain harvested and unharvested crops. Prior to the liquidation, S had deducted, pursuant to
*1091 OPINION
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
*75 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 *1092 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, *76 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*77 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.
*1093 On October 1, 1976, the corporation adopted a plan of complete liquidation under
| 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*78 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: *1094
| 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 |
| Total | 3,309,031 |
*79 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, harvested 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.
*80 On the corporation's return for the taxable year ended January 31, 1977, the corporation deducted all the costs *1095 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 | 5 Income adjustment | |
| 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*81 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*82 in the hands of the estate equal to the fair market value of *1096 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*83 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
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.
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
*84 *1097 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.
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.,
The Supreme*86 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."
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
The Supreme Court began its analysis of the tax-benefit rule in Bliss Dairy by examining the purpose and function of
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" *1099 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.
Like Bliss*88 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
The liquidation in Bliss Dairy took place in a taxable year after the year in which the deductions were taken, whereas the*89 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
*90 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 cultural 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*91 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
Respondent, therefore, asks us to go beyond Bliss Dairy and to hold that deductions for services (such as labor, equipment*92 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
In support of its position, respondent asserts that the Court in Bliss Dairy determined that deductions under
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 *1102 services at issue, then the predicate for deducting the cost of the asset under
*94 We are not at liberty to speculate about the meaning of the words "actually consumed" and "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
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.]
*1103 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.
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.
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 *97 significant expansion of the rule and, in our view, goes far beyond its intended scope. Under respondent's formulation, every business deduction under
Respondent relies on our decision in
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*99 of production, petitioners distributed the plants to its shareholder in liquidation. [
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
In
We agree with the Government*101 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. [
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
In
Lastly, in
It appears that the taxpayer in Ballou Construction did not raise the issue before us here, i.e., whether the *1107 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*104 in place" as the equivalent of the unconsumed feed in Bliss Dairy. The court stated as follows:
The premise of a deduction under
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*105
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;
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*107 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 *108 becomes productive)." H. Rept. 99-841 (Conf.), at II-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 *1109 deductible under
Decisions will be entered under Rule 155.
Nims, J., dissenting: I respectfully dissent. By its action in this case the majority reopens a loophole which the Supreme Court thought it had closed in Hillsboro National Bank v.
*1110 In Byrd, the Commissioner*110 asserted that expenses incurred by nurserymen in growing plants are normally deductible because the plants will be sold to customers in the ordinary course of business. However, since the plants in Byrd were distributed to shareholders in a corporate liquidation, this treatment was fundamentally inconsistent with the purpose behind the
By reading the facts of Byrd selectively, it might be suggested that only the cost of the young plants distributed in liquidation, but not the cost of materials and supplies used to nurture them, were required to be recaptured. This is the only conceivable basis on which Byrd could be distinguished from this case. But to apply this bizarre distinction consistently, the majority should, at a minimum, disallow the*111 cost of seeds. Even the majority must admit that seeds are but the precursors of young plants.
The majority places more weight on the Supreme Court's use of the words "consumption of the asset" in Bliss Dairy (
*1111 Our holding in
Unlike the situation in Bliss Dairy, Byrd and, I submit, the case before us, the taxpayers in Mars and Uncle Ben's did not convert expensed assets to some other, nonbusiness use which was inconsistent with earlier deductions. See
For the foregoing reasons, I would hold for respondent.
Hamblen, J., dissenting. I agree with and join the dissenting opinion of Judge Nims. The action of the majority in this case does more than "reopen a loophole which the Supreme Court thought it had closed in Bliss Dairy"; its action erodes the tax-benefit rule.
The majority suggests that respondent would have us go beyond Bliss Dairy. I, however, submit that respondent is asking us only to be consistent*113 with the rule of that case.
In Bliss Dairy, the Supreme Court established the tax-benefit rule's parameters, stating, "the tax benefit rule will 'cancel out' an earlier deduction only when a careful examination shows that [a] later event is indeed fundamentally inconsistent with the premise on which the deduction was initially based." (Fn. ref. omitted.) Hillsboro National Bank v.
After noting the rule's rationale, the Supreme Court then examined the rule's application. The tax-benefit rule functions on a case-by-case basis. In applying the rule, "A court must consider the facts and circumstances of each case in the light of*115 the purpose and function of the provisions granting the deductions." Hillsboro National Bank v. Commissioner, 460 U.S. at 385.
In the case before us, just as in Bliss Dairy, the applicable statutory provision under which deductions were taken is
*117 *1113 A careful consideration of
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 added.]
Words of import in this regulation include the words "in operation during the taxable year" and those preventing double deductions. The phrase "in operation during the taxable year" necessarily entails the primary activity for which all trades and businesses are formed and managed -- the generation of income. 4 The language preventing double deductions inextricably ties a deduction to income -- to the extent an expense has reduced income generated in one taxable period, it may not reduce income generated in succeeding periods.
*118 Furthermore, we have clearly accepted this link between deduction and income generation. In
*119 *1114 The majority's reliance on "the consumption of the asset" as the overriding justification for the granting of a
*120 As a further comment, the majority's emphasis upon physical consumption of the exact item acquired through the expenditure is an exaltation of form over substance. Just because there has been a physical transformation of seed, fertilizer, water, etc. into an end product (whose value equals or exceeds the cost of production) is not a sound basis for disregarding the spirit of the tax-benefit rule. A requirement that the same physical items be distributed to shareholders is analogous to a requirement that there be an actual recovery of the items previously deducted. Such a requirement of sameness "would introduce an undesirable formalism into the application of the tax benefit rule." 7*1115 Hillsboro National Bank v. Commissioner, 460 U.S. at 382.
*121 I also note that the majority's holding fails to fully consider our decision in
the cost of seeds and young plants which are purchased for further development and cultivation prior to sale in later years may be deducted as an expense for the year of purchase, * * * If the purchased [and mature] plants are not sold in the ordinary course of the taxpayer's trade or business, but are instead converted to a nonbusiness use which does not produce business income, this action would be viewed as inconsistent with the prior deduction, and the tax benefit rule would require that an amount equal to the unwarranted deduction be included in income.
* * * *
[Taxpayers] deducted the cost of young plants purchased for sale in their business*122 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, [taxpayers] distributed the plants to its shareholder in liquidation. It is clear that this treatment is "fundamentally inconsistent" with the purpose for which the deduction was taken. * * * [
As this statement from Byrd makes clear, a taxpayer's liquidating distribution of its marketable products to its shareholders, in lieu of this taxpayer's sale of its products to generate income "to offset [its] cost of production," is "fundamentally inconsistent" with the purpose for which the production costs were deducted. This fundamental inconsistency justifies the tax-benefit rule's application. 9 In the case at hand, Schwartz Farms, by its action of *1116 distributing mature crops to its shareholders, has failed to generate income through the sale of these crops to offset the costs of seed, fertilizer, water, etc. This liquidating distribution represents a fundamental inconsistency*123 associated with the deducted costs and triggers the tax-benefit rule's application.
Moreover, the majority's holding fails to fully*124 consider the decision in
For the sake of argument, I find that the majority is wrong when its focuses on the sand deposit in place as the asset in Ballou which must be "consumed" for purposes of
*127 Though the majority was wrong in focusing on the sand deposit in place as the item subject to consumption, the majority was very correct when it said, "It is clear that the [Ballou] 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." (Emphasis added.) Likewise, the costs deducted by Schwartz Farms in the instant case are directly attributable to the crops which the farm distributed in liquidation. Following the lead of the Ballou court, we should similarly apply the tax-benefit rule to recapture these direct costs, these costs which enhanced the value of a marketable product which was not sold in the normal course of business. 12
*128 *1118 The majority opines that "Under respondent's formulation, every business deduction under
In the instant case, moreover, we are not faced with an unforeseen event. Schwartz Farms voluntarily decided to liquidate. In doing so, the liquidating farm chose not to subject its products to the risk of loss, whether that loss should occur in the market place or from an unforeseen event. It is in the context of this farm's voluntary action that we must consider respondent's argument and apply the tax-benefit rule.
At this point, I also find it necessary to respond to the*129 majority's reliance on section 464 and the special accounting provisions applicable to farmers. The majority's decision to turn to section 464 to add meaning to the term "consume" would suggest that in the future we must similarly search high and low for talismanic words to define the term "consume" within the context of different trades or businesses prior to our applying the majority's rule. That this seems to be the logical result of the majority's analysis should elicit at least a statement of concern from the majority. Furthermore, the majority's use of section 464 as a statutory tool which stymies the proper application of the tax-benefit rule in this case leads to a suggestion that Congress has acted where it indeed has not. Congress did not restrict the tax-benefit rule's application under section 464; it instead established that rule's exclusionary element in section 111. We should not legislate where Congress has *1119 not by implying that Congress did act in wholly unrelated provisions applicable to ongoing business operations.
In responding to the majority's use of the special accounting provisions applicable to farmers as a means of not applying the tax-benefit*130 rule in this case, I again find it instructive to turn to our decision in Byrd. There, we said:
[Section 352 of the Revenue Act of 1978 13*132 ] did not change the nature of deductions available to nurserymen, or the purpose and function of such deductions. The changes made by act section 352 were changes in timing; changes in accounting treatments. Deductions taken by nurserymen and farmers are governed by
The unquestionable consequence of this language and our final ruling in Byrd is that we recaptured a cost of production which had not been recouped through a subsequent*131 sale. We applied the tax-benefit rule, in spite of special accounting provisions and the Byrd producers' need not to accumulate inventories. 14
*1120 As a further comment, I find it necessary to ask just what rule the majority is espousing in this case. To the extent the majority so heavily relies on section 464 and the special accounting provisions applicable *133 to farmers in deciding not to apply the tax-benefit rule, is it suggesting that its holding in this case has reference only to "farmers"? The majority's citing of cases which do not involve farmers, i.e., Tennessee
The majority notes in note 4 of its opinion that the parties to this case have made no suggestion that section 268 is applicable in this instance. However, it is interesting to note the application of this section and its related section 1231(b)(4). 15 If section 1231 applies, then a farmer, under the direction of section 268, must recapture deductions, in the form of "expenses, depreciation, or otherwise," which are attributable to the production of the unharvested crop. These recaptured deductions include those taken in a taxable year other than the year of sale. In applying the*134 tax-benefit rule to the case at hand, I would require of Schwartz Farms no greater burden of tracing and recapturing *1121 of expenses than that required by Congress under section 268.
*135 I also find it odd that the majority couches its discussion of
*136 In sum, the principle laid down by the Supreme Court in Bliss Dairy focuses on transactional parity, which strives to achieve the matching of income and expense, and the tax-benefit rule is triggered by a fundamentally inconsistent event that distorts this matching of income and expense. Thus, the tax-benefit rule applies, without regard to recovery, to fundamentally inconsistent events that distort the matching of income and expense. 17
*137 Correlatively,
Applying these elemental principles to the case before us, it is clear that the fundamentally inconsistent event of liquidation obviated the correlation of crop production expense to the generation of income from the crop. This distortion compels application of the tax-benefit rule in the instant case, as it did in Bliss Dairy.
Because the majority opinion implicitly overrules Byrd, perceptibly discriminates in not applying the tax benefit rule to a large, affluent farming operation, and seriously erodes the rule's application in other areas, and for the reasons above set forth, I respectfully dissent.
Ruwe, J., dissenting: I agree with and join the dissenting opinions of Judges Nims and Hamblen and write this to add two brief observations.
The majority opinion appears to acknowledge that tax-benefit rule*138 principles apply even though the expenditures and liquidation occurred in the same taxable year. In note 8, the majority concedes that the Supreme Court in Bliss Dairy found it of no consequence whether the application of these principles takes place by way of reducing or eliminating a deduction or increasing income. In light of this, I believe that the majority places unwarranted reliance upon section 464 and its allowance of deductions for items "used or consumed." Deductions allowed by section 464 are restricted to deductions "otherwise allowable under this chapter." Since the tax-benefit rule and its effect of canceling out deductions was in effect at the time section 464 was enacted, the first question is whether tax-benefit rule principles effectively precluded deductibility aside from anything contained in section 464. Section 464 itself is irrelevant to this inquiry.
*1123 The majority notes that neither party suggested the applicability of section 268. I feel that section 268 should be mentioned, however, because adoption of the majority opinion will cause different results depending upon whether the tax results of a liquidation are governed by section 336 or*139
*140 The unharvested crops in the instant case were disposed of at the same time as the land, and would have qualified as section 1231 property if a recognizable sale or exchange had occurred.
In
The*141 majority opinion states that the corporation adopted its plan of liquidation under
Application of tax-benefit rule principles to a section 336 liquidation produces the same result with respect to the unharvested crops that section 268 produces in a
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">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., TennesseeCarolina Transportation, Inc. v. Commissioner, 65 T.C. 440">65 T.C. 440 (1975), affd.582 F.2d 378">582 F.2d 378 (6th Cir. 1978), cert. denied440 U.S. 909">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.↩
1. The majority accurately notes that the purpose of the tax-benefit rule is "to achieve rough transactional parity in tax." Throughout their analysis, however, this same majority stresses the deduction of items at the expense of a fully developed discussion related to the second prong of transactional parity -- the generation of income. The majority's decision to ignore income generation obviates what in essence is the sine qua non of transactional parity -- the matching of income and expense. As such, the majority's failure to ask "Where's the income?" reminds one of a hamburger purchaser's failure to ask, "Where's the beef?"↩
2. This regulation was initially issued under the authority of sec. 7805.
1 C.B. 63">1958-1 C.B. 63↩ .3. That a longstanding link exists between a
sec. 162 deduction and the generation of income can be found in tracing the section's statutory roots. In examining the purpose ofsec. 162 , the Supreme Court quoted from hearings before the House Committee on Ways and Means of the 75th Congress and noted the section's 1916 predecessor. A further look to the section's forebears reveals an even closer link between the taking of the deduction and the generation of income. The act of March 3, 1865, provided that "In estimating deductions from income * * * when any person rents buildings, lands, or other property, or hires labor to cultivate land, or to conduct any other business from which such income is actually derived↩, * * * the amount actually paid * * * shall be deducted." Sec. 1 of H.R. 744, 38th Cong., 2d Sess., ch. 78, 13 Stat. 469, 479. (Emphasis added.)4. In its opinion, the majority finds [ILLEGIBLE WORD] necessary to refer to the dictionary definition of "consume." I also find it necessary to [ILLEGIBLE WORD] the definition of "business" and "trade" as found in the Random House College Dictionary. There, "business" is defined as "the purchase and sale of goods in an attempt to make a profit, Random House College Dictionary at 183 (rev. ed. 1982), and "trade" is defined as "any occupation pursued as a business or livelihood." Random House College Dictionary, supra at 1392. (Emphasis added.)
With specific application to the case at hand,
sec. 1.61-4(d), Income Tax Regs. , describes farmers as "individuals, partnerships, or corporations that cultivate, operate, or manage farms for gain or profit↩." (Emphasis added.)5. In Byrd, we summarized and accepted the Commissioner's argument thusly:
"Respondent however contends that petitioners have lost sight of the fact that the deduction in the earlier year authorized by
section 162 is premised on the fact that an expense is necessary to produce income in the ordinary course of one's business. Respondent asserts that expenses incurred by nurserymen in growing plants are deductible because the plants will be sold to customers in the ordinary course of business. Therefore respondent concludes that since the plants were distributed to shareholders in liquidation this treatment was fundamentally inconsistent with the purpose behind thesection 162 deduction. For the reasons set forth below, we agree with respondent. [Byrd, Transferee v. Commissioner, 87 T.C. 830">87 T.C. 830 , 836 (1986), affd. without published opinion829 F.2d 1119">829 F.2d 1119↩ (4th Cir. 1987); emphasis added.]"6. No issue was raised in Bliss Dairy regarding the expensed feed that was consumed by the dairy herd prior to the corporate liquidation. The fact that the issue of consumed feed was not placed in issue in Bliss Dairy should be accorded little or no weight. See
Perkins v. Endicott Johnson Corp., 128 F.2d 208">128 F.2d 208 (2d Cir. 1942), affd.317 U.S. 501">317 U.S. 501 (1943). Based upon the facts in the Bliss Dairy↩ opinion, I doubt that the tax-benefit rule could have properly been applied to the feed already consumed by the dairy herd. The nature of a dairy operation suggests that the primary business is the production and sale of dairy products which are normally produced on a daily basis and sold immediately. Under those circumstances, the cost of consumed feed would properly offset income from the production and sale of dairy products. Deductibility of the consumed feed was not based upon any assumptions that were fundamentally inconsistent with the corporate liquidation.7. The majority's emphasis on the term "consumption" may well instigate before our Court and others a future parade of experts in biology, chemistry, and physics, as both the Commissioner and taxpayers attempt to sway our decision and those of other courts that a particular asset has been fully consumed.↩
8. The young plants in Byrd were inventoried on a yearly basis as if purchased by a cash basis taxpayer.
Byrd, Transferee v. Commissioner, 87 T.C. at 831↩ .9. As a general rule, this Court will not look behind a notice of deficiency to examine the evidence used or the propriety of the Commissioner's motives or administrative policy or procedure in making the determination.
Greenberg's Express, Inc. v. Commissioner, 62 T.C. 324">62 T.C. 324 , 327 (1974);Suarez v. Commissioner, 58 T.C. 792">58 T.C. 792 , 813 (1972). Noting such, we should draw no conclusions from the Commissioner's failure in Byrd to subject further costs of production, other than inventory items, to the recapture of the tax-benefit rule. For a discussion of the tax-benefit rule's application in the context of an unforeseen event, see infra↩.10. We have cited Ballou approvingly and accepted its discussion of the transactional parity underlying the tax-benefit rule. See
Byrd, Transferee v. Commissioner, 87 T.C. at 838↩ .11. The sand deposit in place in Ballou is similar to a crop not yet fully matured and harvested. Both assets represent items that will not be consumed by their producers but instead will be enhanced by further actions taken on the part of their producers. These enhancing actions will be the subject of
sec. 162(a) deductions.Accepting the above proposition and utilizing the logic of the majority, we should hold in this case that, since the enhanced but unsold asset, unharvested crops, has not been "consumed" by its producer, then the costs directly attributable to this unconsumed asset should be recaptured under the tax-benefit rule.↩
12. The majority's statement that no authority has been offered to support respondent's position in this case is inaccurate. This inaccuracy is confirmed by the majority's attempt to cite and distinguish precedent which in actuality supports or in no way contradicts respondent's position. One example is the majority's citing of
Rev. Rul. 85-186 , supra. Regardless of the fact that this ruling simply represents the view of the Commissioner, I point out that the deductions involved in that ruling were taken under sec. 174(a). The purpose and function of sec. 174's granting of deductions may not be in tandem with those undersec. 162 .Additionally, respondent has maintained since at least 1955 a position quite analogous to that which he argues here. In
Rev. Rul. 55-138, 1 C.B. 223">1955-1 C.B. 223 , 224-225, modified on another issue,Rev. Rul. 68-69, 1 C.B. 80">1968-1 C.B. 80 , respondent opined:"This has been done on the assumption that such costs have been a part of the costs incurred in the business of the taxpayer. When the goods become the subject of a contribution or gift they are in effect removed from the business operations of the taxpayer and such costs attributable thereto should likewise be eliminated from business costs."
We have cited
Rev. Rul. 55-138 , supra, and accepted the consequences of the application of the above-mentioned language. SeeMartin v. Commissioner, 56 T.C. 1294">56 T.C. 1294 , 1299 (1971).Finally, we should draw no conclusions from the Commissioner's failure in those cases cited by the majority to assert as deficient amounts items of a character similar to those amounts in question in the instant case. See note 9 supra↩.
13. Sec. 352 of the Revenue Act of 1978, Pub. L. 95-600, 92 Stat. 2846-2847, provided as follows:
(a) Application of Section. -- This section shall apply to a taxpayer who --
(1) is a farmer, nurseryman, or florist,
(2) is on an accrual method of accounting, and
(3) is not required by
section 447 of the Internal Revenue Code of 1954 to capitalize preproductive period expenses.(b) Taxpayer May Not Be Required To Inventory Growing Crops. -- A taxpayer to whom this section applies may not be required to inventory growing crops for any taxable year beginning after December 31, 1977.
(c) Taxpayer May Elect To Change To Cash Method.[0001]T0 -- A taxpayer to whom this section applies may, for any taxable year beginning after December 31, 1977 and before January 1, 1981, change to the cash receipts and disbursements method of accounting with respect to any trade or business in which the principal activity is growing crops.
(d)
Section 481 of Code To Apply. -- Any change in the way in which a taxpayer accounts for the costs of growing crops resulting from the application of subsection (b) or (c) --(1) shall not require the consent of the Secretary of the Treasury or his delegate, and
(2) shall be treated, for purposes of
section 481 of the Internal Revenue Code of 1954 as a change in the method of accounting initiated by the taxpayer.(e) Growing Crops. -- For purposes of this section, the term "growing crops" does not include trees grown for lumber, pulp, or other nonlife purposes.
[Emphasis added.]↩
14. Our action in Byrd supports the notion that accounting rules do not necessarily prevail over general principles of tax economics and substance. Cf.
Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979) .Moreover, in an instance tied to farmers/sharecrop landlords, we have described a special accounting procedure as "a rule of administrative convenience" but have gone on to state that this rule has "no bearing on the underlying question whether potentially taxable income exists."
Parmer v. Commissioner, T. C. Memo. 1971-320 , citingTatum v. Commissioner, 400 F.2d 242">400 F.2d 242 , 247 (5th Cir. 1968, affg.46 T.C. 736">46 T.C. 736↩ (1966). This language would consequently imply that questions of income realization may be addressed irrespective of special accounting rules.15. Sec. 268 provides:
Where an unharvested crop sold by the taxpayer is considered under the provisions of section 1231 as "property used in the trade or business," in computing taxable income no deduction (whether or not for the taxable year of the sale and whether for expenses, depreciation, or otherwise) attributable to the production of such crop shall be allowed.
Sec. 1231(b)(4) states:
(4) Unharvested crop. -- In the case of an unharvested crop on land used in the trade or business and held for more than 6 months, if the crop and the land are sold or exchanged (or compulsorily or involuntarily converted) at the same time and to the same person, the crop shall be considered as "property used in the trade or business." [The above language reflects this section as it appeared in 1975. Changes in the holding period were made for tax years 1977 and 1978.]↩
16. There we said:
"Although the [tax-benefit] rule is generally addressed to situations in which a deduction in an earlier taxable year is related to a recovery in a later taxable year, the same approach has been applied where both deduction and offsetting recovery occur in the same taxable year. See
Connery v. United States, 460 F.2d 1130">460 F.2d 1130 , 1133 (3d Cir. 1972);Spitalny v. United States, 430 F.2d 195">430 F.2d 195 , 198 (9th Cir. 1970);Anders v. United States, 462 F.2d 1147">462 F.2d 1147 , 1149 (Ct. Cl. 1972), cert. denied409 U.S. 1064">409 U.S. 1064 (1972), rehearing denied410 U.S. 947">410 U.S. 947 (1973); Estate of David B. Munter, [v.Commissioner, 63 T.C. 663">63 T.C. 663 , 674-677 (1975)]. Here, accrued liabilities were satisfied during the same taxable years by crediting surplus bond proceeds against such liabilities -- indeed, the liabilities arose and the funds were credited on the same days -- and the tax benefit rule should be applied. * * * [Consolidated Foods Corp. v. Commissioner, 66 T.C. 436">66 T.C. 436 , 445 (1976).]"Moreover, the Supreme Court has cited approvingly the cases listed in the above quotation. See Hillsboro National Bank v. Commissioner, 460 U.S. at 396 and
402 . Spitalny was specifically cited as standing for the proposition that "when deduction and liquidation occur within a single year, though tax benefit rule does not apply, principle does." Hillsboro National Bank v. Commissioner↩, 460 U.S. at 401.17. The Supreme Court has mentioned that a rancher, a taxpayer similar to a farmer, who uses the cash method possesses substantial flexibility in determining the year in which income is realized. However, the defect of this method is that it produces a bunching of income in the year of sale and "an inaccurate matching of income from the sale of the livestock with the expenses incurred in raising the animals."
United States v. Catto, 384 U.S. 102">384 U.S. 102 , 111↩ n. 15 (1966). (Emphasis added.) To the extent the tax-benefit rule requires a matching of income and associated expense, the rule would override the cash method's defect.1. Sec. 268 provides:
Where an unharvested crop sold by the taxpayer is considered under the provisions of section 1231 as "property used in the trade or business," in computing taxable income no deduction (whether or not for the taxable year of the sale and whether for expenses, depreciation, or otherwise) attributable to the production of such crop shall be allowed.
Sec. 1231(b)(4) provides:
(4) Unharvested crop. -- In the case of an unharvested crop on the land used in the trade or business and held for more than 6 months, if the crop and the land are sold or exchanged (or compulsorily or involuntarily converted) at the same time and to the same person, the crop shall be considered as "property used in the trade or business."↩