Tax Court Blesses "Double Deduction" for Same Input Costs

December 13, 2016 | Kristine A. Tidgren

While death may be beneficial for tax purposes, it is difficult to regard it as a tax avoidance scheme.

This line is a great summary of the reasoning of the Tax Court in a recent case that illustrates an interesting interplay between cash accounting and death.

The facts in Backemeyer v. Commissioner are not atypical. In 2010, a sole proprietor farmer prepaid and deducted the cost of his 2011 inputs as ordinary and necessary business expenses. In 2011, before actually using those inputs, the farmer died. His wife inherited his assets—including the inputs purchased in 2010—and they received a step-up in basis.

When she took over the farming operation, the wife used the husband’s inputs and took a deduction for their fair market value, which was the price her husband had paid for them in 2010. The husband’s estate was not subject to estate tax.

The IRS, not appreciating that the same seed, fertilizer, and herbicides were deducted twice, first by the husband and then by the wife, disallowed the deduction and assessed an accuracy-related penalty.

On appeal, the Tax Court sided with the wife. The court ruled that the inputs were properly deducted both times as ordinary and necessary business expenses. The major consideration was whether the tax benefit rule required recapture of the husband’s 2010 deduction upon his 2011 death.

The tax benefit rule applies where “a careful examination shows that the later event is indeed fundamentally inconsistent with the premise on which the deduction was initially based.” Under this rule, an amount must be included in gross income in the current year if, and to the extent that:

(1) The amount was deducted in a year prior to the current year,

(2) The deduction resulted in a tax benefit,

(3) An event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and

(4) A non-recognition provision of the Internal Revenue Code does not prevent the inclusion in gross income.

The Tax Court reviewed these factors and determined that, while the first two were met, the last two were not. The court distinguished the facts from those of Bliss Dairy, Inc. v. Commissioner, 460 U.S. 370 (1983), where the Supreme Court ruled that the tax benefit rule did apply. In Bliss Dairy, the corporate taxpayer prepaid feed expenses, deducting them as ordinary and necessary business expenses in one year. The Dairy then adopted a plan of liquidation early in the following year. Upon liquidation, the corporation distributed its assets (including a significant amount of the feed) to its shareholders. Relying on IRC § 336, the Dairy recognized no income on the liquidation. The shareholders continued to operate the dairy in an unincorporated form and calculated their basis in the assets under IRC § 334(c) (which gave them a positive basis in the feed). When the shareholders used the feed, they deducted their basis in the feed as an ordinary and necessary business expense. The IRS argued that the Dairy should have recognized income for the value of the unused feed in the year of the liquidation. The lower courts (including the 9th Circuit) sided with the shareholders. But, on appeal, the United States Supreme Court reversed. The Court ruled that the liquidation of the corporation resulted in conversion of the cattle feed from a business to a nonbusiness use, representing an action inconsistent with the prior deduction and requiring application of the tax benefit rule.

In distinguishing the facts of Backemeyer from those of Bliss Dairy, the court reasoned that the distribution to shareholders of expensed assets in Bliss Dairy was analogous to converting those assets to personal use. Here, the court found that neither the farmer’s death, nor the distribution of the farm assets to his wife was fundamentally inconsistent with the premise upon which the business expense deduction was based. The court stated that the estate tax effectively “recaptures” IRC § 162 deductions by way of its normal operation, obviating any need to separately apply the tax benefit rule. Even though he farmer’s estate did not owe any estate tax, the fair market value of the inputs was considered for purposes of determining whether such liability existed. Recapturing the deduction could effectively result in a “double taxation” of the value of the farm inputs.  

The court also noted that the Supreme Court had drawn a “line between merely unexpected events and inconsistent events.” While liquidation was a planned event, death “ordinarily does not involve such planning.”

The court stated,While death may be beneficial for tax purposes, it is difficult to regard it as a tax avoidance scheme.” Death, the court stated, is the “quintessential merely unexpected event.” “We are loath to interpret Bliss Dairy to stand for the proposition that any time a sole proprietor dies, all of his expensed assets are subject to recapture.” The court also stated it was improper to characterize the deductions at issue as “double deductions” because the estate tax intervened between the two. It was only because of the step-up in basis that the issue arose (without a basis, the wife would have had no expenses to deduct). And that makes sense.

The case is Backemeyer v. Commissioner, 147 T.C. No. 17 (Dec. 8, 2016).

We’ll keep you posted.