Federal Appeals Court Slams Door on IRS Interpretation of “Farming Syndicate Rule”

by Roger A. McEowen

IRS has a long history of challenging taxpayers that they believe are distorting income reporting by use of the cash method of accounting.[1]  They were at it again in a case involving a Texas cattle and horse breeding limited partnership that the IRS said was a tax shelter by virtue of being a “farming syndicate” and, therefore, was not entitled to use cash accounting.  However, the court disagreed rather sternly.[2]

Limitation on Deductions for Certain Farming/Ranching Operations

In the farm and ranch sector, that alleged distortion often arises in the context of pre-payment for inputs such as fertilizer, seed, feed or chemicals.  Various tests and rules have been adopted over the years to deal with material distortions of income when pre-purchases are involved.[3]  One of those rules, which is designed to place a limitation on deductions for farming operations, was developed in the 1970s and is known as the Farming Syndicate Rule.[4]  The Congress enacted the rule in 1976, and it eliminates “farming syndicates” from taking deductions for feed, seed, fertilizer and other farm supplies before the year in which the supplies are actually used or consumed.  The rule establishes two tests for determining whether a farming syndicate is present.  A farming syndicate is (1) a partnership or other enterprise (except a regularly taxed corporation) engaged in farming if the ownership interests in the firm have been offered for sale in any offering required to be registered with any federal or state securities agency,[5] or (2) a partnership or other enterprise (other than a C corporation) engaged in farming if more than 35 percent of the losses during any period are allocable to limited partners or “limited entrepreneurs.”[6] 

IRS Position

The “farming syndicate” rule does not impact many farming and/or ranching operations, but it does catch some of the extremely large operations and a few individuals who are inactive investors in farming operations.  That’s because there is an exception to the rule for holdings attributable to “active management.”  If an “individual” has actively participated (for a period of not less than 5 years) in the management of the farming activity, any interest in a partnership or other enterprise that is attributable to that active participation is deemed to not be held by a limited partner or a limited entrepreneur.[7]  That means that the interest doesn’t count toward the 35 percent test.  But, IRS has taken a strict interpretation of the statute.  In the IRS view, the exception for active management only applies to an “individual.”[8]  Thus, in C.C.A. 200840042[9] the Chief Counsel’s office determined that a partnership interest held by an S corporation with only one shareholder was to be treated as held by a limited partner for purposes of the farming syndicate rule.  The partnership raised and bred livestock, and its members were two trusts along with the S corporation.  The S corporation was owned by a trustee who was also a beneficiary of the trusts.  One of the trusts was the general partnership of the partnership.  The partnership reported income on the cash method, but IRS took the position that the partnership interest that the S corporation held had to be treated as a limited partner interest because it wasn’t held by an “individual.”  This was the result, according to the IRS, even though the S corporation’s sole shareholder was an individual.  Thus, for purposes of the farming syndicate rule, the interest held by the S corporation was treated as an interest that was held by a limited partner.

Texas Case

In a recent case involving a Texas cattle and horse breeding limited partnership,[10] the court held that the ranch qualified for the active participation exception to the farming syndicate rule even though the majority owner actively participated in managing the cattle operation through the owner’s wholly-owned S corporation.  The court noted that the west Texas operation had been family-run for many generations dating back into the 1800s, with the current majority owner family member owning her interest via an S corporation.   There was no question that that majority owner managed the operation and would satisfy the active management test in her own right.  But, IRS said the farming syndicate rule was triggered and cash accounting was not available because the ownership interest was held in an S corporation rather than directly by the majority shareholder as an individual.  Consequently, IRS said that the partnership could not use cash accounting for the years in issue – 2005-2007.  The limited partnership paid the alleged deficiencies and sued for a refund in federal district court.  The district court ruled for the limited partnership.

The IRS appealed, continuing to maintain that the majority owner’s interest in the limited partnership via her S corporation barred the active management exception from applying.  The court disagreed, largely on policy grounds.  The court noted that the Congressional intent behind the active management exception of I.R.C. §464(c)(2)(A) was to target high-income, non-farm investors, not the type of taxpayer that the majority owner represented.  The court noted that the statutory term “interest” was not synonymous with legal title or direct ownership, but rather was tied to involvement with or participation in the underlying business.  Thus, the court determined that there was no basis for distinguishing between “the partnership interest of a rancher who has structured his business as a sole proprietorship and a rancher who has structured his business as [a subchapter S] corporation.”  The term “individual” was used in the statute to refer to the provision of active management rather than in reference to having an interest in the activity at issue.  The court underscored its holding by noting that the majority owner’s “business and ownership history with these ranches is the very antithesis of the 'farming syndicate' tax shelters that §464 was enacted to thwart.”

Conclusion

The court’s opinion provides needed guidance on the narrow interpretation of the farming syndicate rule by the IRS.  The opinion is binding authority inside the Fifth Circuit.  That’s Louisiana, Mississippi and Texas.  Whether IRS will continue to maintain its position outside the Fifth Circuit remains to be seen.