Considering the Residual Fertility Deduction

In recent months, I have received many questions from farmers and their advisors about the so-called “residual fertility” deduction. Although farmers have been taking a limited deduction for the residual fertilizer purchased along with their farmland for many years, a push to extend and expand this practice beyond the traditional approach has been growing.

Today I seek to review the applicable law and highlight concerns about several aggressive positions. In so doing, I note the lack of authoritative guidance and issue a reminder that deductions from income are available only through legislative grace.[1] Taxpayers bear the burden of proving entitlement to any deductions claimed.[2]

Tax Treatment of Applied Fertilizer

An understanding of a possible deduction for residual fertility must begin with a discussion of the tax treatment of applied fertilizer.

Historical Background

Before Congress codified I.R.C. § 180 in 1960, farmers and the IRS disagreed about the tax treatment of fertilizer expense. Farmers often deducted the cost as an ordinary and necessary business expense, but the IRS argued—and the courts affirmed—that the cost had to be capitalized and amortized over the fertilizer’s period of exhaustion.[3]

In 1947, the IRS ruled that the cost of lime spread on farmland is an exhaustible capital expenditure that should be amortized over the period of its effectiveness if the benefit of the liming extends substantially beyond one year.[4] The IRS ruling, as well as the earlier cases, were based upon the general tax principle that if the benefits of an expenditure extend substantially beyond the close of the tax year, the expenditure may not be deductible or may be deductible only in part for the tax year in which it is made.[5] The 1947 guidance likened this treatment of fertilizer expenditures to amortizing the cost of a pre-paid multi-year insurance premium on a pro rata basis over the years to which the premium applies.[6] The IRS also suggested deducting more of the cost in the years when effectiveness is greater. “If it definitely appears that the benefit or effectiveness of liming will extend over an estimated period of several years, and that such benefit or effectiveness will be much greater in the early part of such period than in the later part thereof, amortization and deduction of its cost may be made accordingly.”[7]

Although not explicitly stated, the courts and the IRS appear to have treated the lime as an intangible asset, amortizable over its useful life.[8]

Section 180

In 1960, Congress determined that capitalizing the cost of fertilizer was “contrary to the long-accepted and widespread practice [by farmers] of deducting fertilizer and lime expenditures in the year they were paid or incurred.”[9] In response Congress passed I.R.C. § 180, which applied to taxable years beginning after December 31, 1959. Today, § 180 continues to allow farmers to elect to presently deduct (and not capitalize) expenses paid or incurred during the taxable year for the “purchase or acquisition” or the application of “fertilizer, lime, ground limestone, marl, or other materials to enrich, neutralize, or condition” “land used in farming.”[10] Specifically, this yearly election is available only to those “engaged in the business of farming,” which includes farmers and crop share landlords. It is not available for the cost of fertilizer used to first prepare land for farming.[11]

Farmers who do not make the election under § 180 to presently deduct the cost of fertilizer may charge the expenditures to a capital account and amortize the cost over the period of the fertilizer’s effectiveness.[12] Thus, when it comes to fertilizer expenditures, farmers may choose between a full expense deduction or a deduction over the course of several years. These rules are well established.

Tax Treatment of “Residual Fertilizer Supply”

When farmers purchase farmland, they may allocate a portion of the purchase price to the fence or the drainage tile or the single purpose buildings on that land. The farmer may then expense the assets under I.R.C. § 179, take additional first year depreciation, and/or depreciate the cost of the asset over its useful life. Is there a similar cost recovery option for residual fertilizer supply purchased with the land? In other words, can a purchaser of farmland allocate a portion of the purchase price to the value of excess fertility on the land?

TAM 9211067 (12/31/1991)

 In 1991, the IRS issued a technical advice memorandum (TAM) suggesting there may be a deduction available for the value of residual fertilizer purchased with farmland.[13] In the TAM, the IRS denied the deduction to the taxpayer, but took time to set forth the facts a taxpayer must establish to support such a deduction.

The taxpayer was a corporate farm owned by two shareholders who were also employees of the corporation. In 1988, the shareholders purchased farm property, which included land and a dwelling. The corporation purchased the other buildings, irrigators, grain bins, and “residual fertilizer supply.” The residual fertilizer supply (also called by the IRS an “increased level of fertilizer in the soil”) allegedly arose because the seller, who had owned the land for 14 years, applied a “semi-truck load” of fertilizer to the land each year.

The shareholders rented the land to the corporation to grow crops, and the corporation sought to amortize the cost of the so-called residual fertility supply over 7 years.

The IRS denied the deduction. Although stating that “capitalized farm fertilization costs may be amortized,” the IRS first found that a taxpayer must be the beneficial owner of the fertilizer to take an amortization deduction. Here, the IRS reasoned, the alleged residual fertilizer supply was incorporated into the land and for all practicable purposes was inseparable from the land. Although the corporation supposedly purchased the residual fertilizer supply from the shareholders, the IRS noted that it could only realize a benefit from that fertilizer by entering a lease with the shareholders, who owned the property. As such, the IRS found that the shareholders and not the corporation were the beneficial owners of any residual fertilizer supply. The corporation could thus not deduct any of its costs related to the residual fertilizer supply.

The IRS next set forth additional requirements to claim an amortization deduction for exhaustion of residual fertilizer acquired with land and the reasons why this taxpayer fell short:

1. The taxpayer must establish the presence and the extent of the fertilizer. The IRS found the taxpayer in this case did not prove this for two reasons:
   • The taxpayer had the soil tested to ascertain the level of its fertility, but the taxpayer did not measure, nor was data provided to indicate the level of soil fertility attributable to fertilizer applied to the land by the previous owner.
   • The data the taxpayer provided about the level of fertility for similar parcels of land in the area did not provide a basis upon which to measure the increase in the level of fertility in the land in question. Because of the variability of soil fertility in general, the IRS stated that comparison studies do not provide a basis upon which to measure the increase in the level of fertility in the land in question.
2. To amortize the cost of fertilizer over time, the taxpayer must in fact be exhausting the fertilizer in the soil. The IRS found the taxpayer did not establish this, again citing two reasons:
   • The taxpayer submitted soil test reports evidencing the level of fertility in the soil, but the reports showed that the level of fertility was not declining.
   • The taxpayer showed no evidence indicating the period over which the fertility attributable to the residual fertilizer would be exhausted or even if it was declining at all.

While a TAM issued after October 31, 1976, can constitute substantial authority for a position taken on a tax return,[14] it cannot be cited as precedent. In other words, a TAM is not sufficient to uphold a position, but it may help a taxpayer avoid accuracy related penalties. Here it should be noted that the persuasiveness of the 1991 TAM—as it applies to authorizing a deduction for residual fertilizer supply—is limited because the IRS denied the deduction to the taxpayer for multiple reasons. Even so, it is instructive. 

1995 IRS Internal Guidance

In 1995, the IRS issued a Market Segment Specialization Program guide to auditing the income tax return of grain farmers.[15] In this internal document, which has long been out of publication, the IRS suggested that a deduction may be possible for residual fertilizer supply. The following paragraph, which does not constitute substantial authority, reiterates the requirements suggested in the earlier TAM:

… a farmer might allocate part of the purchase price of a piece of land to residual fertilizer (from previous applications which has not been depleted by crop production), claiming that although the residual fertilizer raised the cost of the land, it will be exhausted during crop production. By assigning part of the cost of the land to residual fertilizer, the farmer lowers the cost of the land, which is nondepreciable. The IRS has denied such deductions when the farmer was unable to provide data indicating the level of soil fertility attributable to the previous owner. The farmer should be able to prove beneficial ownership of the residual fertilizer supply, the presence and extent of the residual fertilizer, and that the residual fertilizer is, in fact, being exhausted.

What This Means

No cases, regulations, or revenue rulings specifically address a deduction for the cost of residual fertilizer acquired with farmland, but the TAM and the MSSP suggest that it may be reasonable to amortize the cost of residual fertilizer supply over its useful life as long as several conditions are met. 

• The residual fertilizer supply must be attributable to fertilizer applied by the prior owner that has not yet been depleted by crop production. This link cannot be presumed. It must be proven through soil testing and other data (perhaps fertilization records of the seller).
• The taxpayer must show that the residual fertilizer supply is declining. A deduction cannot be taken merely because a purchased farm has higher fertility levels than neighboring farms.
• The taxpayer must be the beneficial owner of the residual fertility supply, meaning they must own the land from which the fertility supply is inseparable.

No authority addresses whether a present deduction for this residual fertilizer supply may be taken under I.R.C. § 180. The taxpayer in the TAM was seeking to amortize the cost of the residual fertilizer over seven years. Even so, many farmers have taken the I.R.C. § 180 deduction for the cost of allocable residual fertilizer acquired with the land. This seems a reasonable approach if the farmer’s deduction is directly attributable to purchasing unexhausted fertilizer that has been applied to the land. Section 180 is an expensing tool, much like I.R.C. § 179. If the cost is eligible for amortization, it may be eligible for expensing if the other requirements of I.R.C.§ 180 are met:

• The taxpayer pays money or incurs expenses for the “purchase” or “acquisition” of “fertilizer, lime, ground limestone, marl, or other materials to enrich, neutralize, or condition land used in farming” (see above for the requirement that residual fertilizer supply is attributable to past fertilization)
• The taxpayer is in the “business of farming,” which includes crop share, but not cash rent, landlords
• The land is “used in farming,” meaning that it is used for the production of crops or the sustenance of livestock. This deduction is not allowed for fertilizer used to first prepare land for farming.
  • Note: Unless a livestock pasture has been fertilized, there is no support for taking a residual fertilizer deduction for pastureland.

What About the Seller?

As noted above, buyers of farmland must complete a purchase price allocation to determine which portion of the sales price is allocable to assets that can be expensed, depreciated, or amortized. Conversely, the seller must determine which portion of the sales price is allocable to the land and which portion is allocable to assets that have been depreciated, expensed or amortized. Gain from the sale of land is generally subject to long-term capital gain treatment, whereas gain from the sale of other assets is often subject to ordinary income tax rates. Thus, in completing this allocation, the buyer and the seller have different incentives.

If the seller is disposing of a trade or business, the law requires both the buyer and the seller to file Form 8594 listing the allocation of the purchase price for each asset.[16] In this case, the allocations must line up. Outside of the sale of a business, it is not legally required that the allocation of the seller matches the allocation of the buyer. No Form 8594 is required. On audit, however, the IRS can examine the returns of both parties to determine whether the reported allocations were reasonable.

In the case of a deduction for residual fertilizer supply, it is best practice to work with the seller to establish the value of the residual fertility and document that in the sales contract. On audit, this documentation would be strong evidence supporting the reasonableness of the deduction. It appears that the seller of the residual fertility must pay ordinary income tax on the portion of the sales price allocable to the residual fertility supply.[17]

Deductions Outside of These Parameters?

The limited authority reviewed above suggests that a modest deduction may be allowed for the value of the residual fertilizer supply purchased with farmland. The deduction amount under this approach should, it would seem, generally correspond to the reasonable value of unexhausted fertilizer that has been applied to the land.[18]  A farmer’s ability to deduct the cost of residual fertilizer flows from the farmer’s right to deduct the cost of fertilizer in the first place. The farmer is purchasing a valuable crop input that is now integrated into the soil, but still available for use. 

Recently, I have been hearing of very high values assigned to residual fertility, yielding very large I.R.C. § 180 deductions. It appears these taxpayers are going beyond the principles discussed above to take a deduction based upon the value of all nutrients in the soil. The nutrients they are valuing have no necessary link to fertilizer that was applied by the prior owner. I find no legal support for this practice. First, as discussed above, I.R.C. § 180 is only available for the purchase of fertilizer, not for the purchase of “soil nutrients.” Additionally, the limited guidance available instructs that those wishing to amortize the cost of residual fertilizer must demonstrate a link between any residual fertilizer supply and past fertilizer applications.

Beyond that, courts have specifically stated that farmers may not take a depreciation or depletion deduction for the exhaustion of soil nutrients generally.

Depreciating Soil Nutrients

Farmers cannot depreciate the cost of their land. Treas. Reg. § 1.167a-6(b), for example, states that farmers may claim a reasonable allowance for depreciation on farm buildings (except a dwelling occupied by the owner), farm machinery, and other physical property, but this does not include land (emphasis added). The tax court has explained that this means “owners of farmland are specifically denied a deduction for exhaustion and wear and tear due to erosion, wind, or privation of soil nutrients”[19] (emphasis added).

In 1977, the Fifth Circuit Court of Appeals addressed a farm taxpayer’s claimed depreciation of peat soil.[20] In A. Duda & Sons, Inc. v. U.S., the topsoil of the farmer’s land consisted of peat and muck soil composed of partially decomposed plant deposits. The soil was uniquely rich and had a value greater than other soils. To cultivate vegetables on the land, the farmer had to drain and compact the soil and apply various chemicals. This caused his heavily carbonized soil to oxidize and subside at a rate of 15 inches in the first year and 1.1. inches thereafter. The farmer sought to take depreciation and depletion deductions for the vanishing peat soil, which the IRS denied.

On appeal, acknowledging that land is not a depreciable asset for tax purposes, the taxpayer argued that the peat soil was an exhaustible capital asset separate from the underlying land. With respect to this claim for depreciation, the court stated, “all topsoil is subject to the oxidation of its organic constituents, to water and wind erosion, and other kinds of ‘wear and tear.’ [Here] the taxpayer makes no additions to or improvements on the land but seeks to depreciate the land itself”[21] (emphasis added). The court thus ruled that the taxpayer was not entitled to depreciation deductions for the subsidence of the peat soil. Likewise, the law does not appear to support a depreciation deduction for the exhaustion of nutrients comprising the soil.[22] It appears that any deduction for unexhausted fertilizer supply must flow from the past application of fertilizer, which is an addition to the land.

Depleting Soil Nutrients

In Duda, the Fifth Circuit also found that the taxpayer was not entitled to a depletion deduction for the wasting of peat soil. The court first explained that the depletion deduction is totally dependent upon statute and has no independent significance in tax law as a legal or equitable principle.[23] After lengthy consideration of the statute and its history, the court suggested that the kinds of depletion deductions encompassed by IRC § 611 do not include the situation in which a natural asset wastes in place.[24] The court stated that the depletion deduction appears limited to cases in which the asset is recovered or extracted and that “extraction or severance is bound up with the depletion deduction.”[25] The court noted that if the farmer were allowed a deduction for the peat soil, another farmer should be allowed a depletion deduction for the exhaustion of the nutrients in his soil attributable to, say, cotton farming.”[26] After noting that this would present a new set of difficulties for administering the depletion deduction, the court declined to extend the general depletion provisions to the situation where an asset is wasting in place, as opposed to extracted and sold. “It may be that Congress intends to grant deductions in these cases. If so, we must insist that it address itself specifically to the case of a natural asset wasting in place.”[27]

Prior courts had explained that farmers cannot take a depletion deduction to recover the cost for the exhaustion of soil nutrients. In 1963, the tax court denied a depletion deduction to a producer of sod on the basis that the taxpayer failed to establish the amounts of depletion he claimed.[28] However, in recognizing that it may be possible to take a depletion deduction for the cost of sod, the court distinguished the production of sod from ordinary farm activities, “In this it differs from other farming activities where that which is taken from the soil is its nutrients. In the ordinary farming operation, the soil can be reconditioned by fertilizers designed to replace the plant food consumed in the farming operation.” [29]

In 1976, in the Meyers case, the tax court held that topsoil sold by a taxpayer was a "natural deposit" subject to the depletion allowance under IRC § 611.[30] Fundamental to its determination was “the ultimate exhaustibility of the natural resource on which depletion is claimed.”[31] Here, the taxpayer established that his topsoil, removed with the extraction of sod for sale, would be exhausted in 16 cuttings. The court explained, “Since sod is by definition a combination of soil and plantlife, the loss of topsoil suffered in a sale of sod cannot be considered minimal…In each case some topsoil is being physically removed, so that after 16 cuttings the layer of topsoil on petitioner's land would be totally exhausted. Hence, there is an actual loss of soil which results in eventual exhaustion of petitioner's capital investment in a natural resource, precisely the circumstances in which a depletion allowance was intended.”[32]

The IRS argued that the taxpayer’s activities were farming activities and that, as such, depletion was not allowed. The taxpayer could instead restore the productivity of the land and deduct the cost as a business expense.[33]  The court rejected that argument, explaining that it would be an “unnecessary overgeneralization to treat the cultivation and sale of sod as we would a purely farming activity.”[34] There is, the court stated, “a difference between the physical removal of topsoil with sod and the diminution in land value resulting from the exhaustion of soil nutrients with the planting of crops.”[35] The latter can be replenished with fertilizer, the former cannot. 

After the Meyers case, the IRS revoked Rev. Rul. 54-241, 1954-1 C.B. 63, which had held that sod and balled nursery stock are not subject to the allowance for depletion. The IRS instead held that cost depletion of top soil is allowable to taxpayers upon the sale of sod or balled nursery stock.[36] The new ruling stated that taxpayers claiming cost depletion of top soil upon the sale of sod or balled nursery stock must establish their basis for depletion in the top soil, and the amount of top soil exhausted with the removal and sale of sod or balled nursery stock during the taxable year.[37] In other words, depletion applies to sod or balled nursery stock that is removed and sold. It does not apply to soil nutrients that are exhausted over time. Crop production is a purely farming activity for which no depletion deduction has been authorized.[38]

Authorities discussing the depletion and depreciation deductions have reasoned that farmers are not allowed a depreciation or a depletion deduction attributable to the exhaustion of nutrients in their soil. This is because soil nutrients can be replenished by fertilizer and farmers are allowed a deduction for the cost of that fertilizer. It appears that any deduction for residual fertilizer supply must be grounded in that principle.

Conclusion

Despite limited authority on the subject, it appears reasonable for a farmer to take a deduction for the value of residual fertilizer supply purchased along with farmland if several conditions are met: the farmer must show the extent of the residual fertilizer supply, the farmer must show that the residual fertilizer supply is attributable to fertilizer applied by a prior owner, and the farmer must show that this residual supply is declining. These facts must be established through soil testing. As detailed above, it appears that a farmer’s authority to deduct the cost of residual fertilizer flows from the farmer’s right to deduct the cost of fertilizer in the first place. Depreciating or depleting the value of soil nutrients has not been sanctioned by the IRS or the courts.

When evaluating possible deductions for residual fertility, farmers and their advisors should be aware of the lack of legal support for the following practices:

• Deductions larger than the value of fertilizer that has been applied to the land by prior owners.
  • Taking large deductions unrelated to the value of past fertilizer applications ignores guidance specifying that residual fertilizer supply must be attributable to past fertilizer applications. Additionally, it appears that a deduction is only available if the nutrients from fertilizer are being exhausted over a predictable number of years.
  • An IRS auditor may track the claim of residual fertilizer supply back to the seller. The veracity of evidence submitted to establish its presence is likely weakened if the contract did not mention the residual fertilizer supply or if the seller did not report the sale of the so-called residual fertility asset.
• Taking a deduction for non-fertilized rangeland or pastureland.
  • Neither the courts nor the IRS have sanctioned a depreciation or depletion deduction for the value of nutrients inherent in the soil. The only available guidance requires proof that the residual fertility supply arose from the past application of fertilizer. As such, there is no legal support for claiming a residual fertilizer deduction for unfertilized rangeland or pastureland.
• Taking a deduction for land purchased many years ago.
  • It appears that a residual fertilizer deduction requires proof of the extent of the residual fertilizer supply, evidence that the supply is linked to past fertilizer applications, and data showing the rate at which the supply is being exhausted. It is difficult to see how this data could be collected years after the purchase. As discussed above, the risk of the IRS rejecting the deduction is also increased if the value of the residual fertilizer is not included in the sales contract. That is not possible if the deduction is an afterthought years after purchase.

This remains an area ripe for statutory, regulatory, or judicial guidance. Any tax position taken without clear guidance comes with risk. Until authoritative guidance is issued, taxpayers and their advisors must consider the level of risk associated with various deductions for residual fertility. They should also recognize that if the IRS disagrees with their position on audit, they could be liable for penalties[39] if the position is found to be unreasonable.[40]