Assignment of Income Doctrine Nabs Iowa Farmer

October 13, 2010 | Roger McEowen

Overview

A fundamental tax principle is that income is taxed to the party that earns it.  However, when an ongoing business changes form, income can end-up being reported by the wrong taxpayer.  That’s especially the case with crop farming and livestock operations.  Any change in the form of the business will likely occur in the middle of the business cycle.  So, for example, when a sole proprietorship farming operation incorporates, a mid-stream incorporation may occur.  The farmer may have incurred substantial expenses in putting the crop in the ground which were incurred pre-incorporation and then have income from the sale of the crops post-incorporation.  If the expenses are reported on the farmer’s individual return with no offsetting income, that could result in a net operating loss.  If the income is reported as corporate income, that could end up being taxed at lower corporate rates and may also minimize self-employment tax.  In such situations, IRS may challenge the reporting as improper.  One of those weapons is the assignment of income doctrine.  The doctrine provides that a taxpayer cannot escape tax liability for income the taxpayer earned by transferring the income to another person or entity.  In a recent Tax Court case from Iowa, the doctrine was utilized against a farm couple.

Facts of the Case

The petitioners are a farm couple in northwest Iowa.  The husband operated a sole proprietorship corn and soybean farming operation.  Income from the operation consisted of proceeds from the sale of crops and the receipt of federal farm program payments.  The crop income and the farm program income was deposited into the couples’ personal farm account.  In September of 2005, the couple formed a corporation and named themselves as the sole shareholders and directors.  They didn’t execute a deed, sales contract or any written agreement that transferred or leased the couples’ farmland to the corporation.  What they did transfer to the corporation was $10,000 from their personal bank account to establish the corporate account.  

After incorporation, in October 2005, the husband deposited the 2005 government payments (except one) into their personal account.  That one government payment was deposited into the corporate account.  Later in October, the husband transferred the balance of the USDA payments and the crop sale proceeds to the corporate account.  For 2005, the petitioners reported $195,938 from crop sales and $61,416 in farm program payments on Schedule F. They claimed an expense deduction for $44,165 of USDA payments and $20,532 of crop sale proceeds that they had put in the corporate account.  They reported $481 of self-employment tax liability.  For the fiscal year ending September 30, 2006, the corporation reported $370,647 of income, but completely offset it by expenses.

The IRS disagreed with the petitioners’ reporting - attributing to the petitioners all of the funds that were deposited into or transferred to the corporate account in 2005 (except the one government payment).  IRS increased their tax liability to $28,445 under the assignment of income doctrine.  While the petitioners argued that they transferred their crops to the corporation, IRS didn’t agree.  IRS noted that the petitioners had already reduced the crops to income before transferring the crop income (proceeds) to the corporation.  Consequently, the petitioners had earned the income before transferring it to the corporation.  Likewise, because the USDA payments were issued in the petitioner’s names, those payments were not corporate income.  

The court agreed with the IRS, applying the assignment of income doctrine.  The court specifically noted that the petitioners had no documents indicating that they had actually transferred the land or the crops to the corporation.  All they transferred was the proceeds of the crops and the government payments that had been paid to them personally.  The petitioners also made a strange argument that they shouldn’t be taxed on the income because they organized the corporation tax-free in an I.R.C. §351 exchange.  The court didn’t need to analyze that argument – simply noting that it was misplaced.  

The court also hit the petitioners with an accuracy-related penalty.  They didn’t reasonably rely on their return preparer and didn’t provide any evidence concerning the preparer’s experience or qualifications or that they had provided the preparer with all of the necessary and accurate tax information to prepare their returns.  Slota v. Comr., T.C. Sum. Op. 2010-152.