Farming Activity Was Not a Trade or Business; Expenses Must be Capitalized as Start-Up Costs

(Parker Tax Publishing February 2021)

The Tax Court held that a taxpayer's farming activity did not rise to the level of a trade or business and thus the related expenses were start-up costs that were not currently deductible. The court also disallowed losses relating to a property that was not in a rentable condition, but disagreed with the IRS that losses on certain other properties were passive activity losses. Legarcie, T.C. Memo. 2021-9.

Since 2007, Maritza Legarcie has carried on a farming activity on a 6,500-acre tract of land, Oasis del Eden (property), in Mexico. She, on her own and later with her husband, William Costello, reported net losses from the farming activity on Schedule F, Profit or Loss From Farming. This activity was reported for every year beginning with 2007. That was the year Ms. Legarcie decided to raise chickens on the property to sell for meat. That activity did not go well and the only sale that Ms. Legarcie reported for 2007 through 2011 was $264. In 2011, Ms. Legarcie switched from raising chickens for meat to raising them for egg production. By 2012, however, she had determined that she would not make money with commercial egg production because of an upward trend in the price of chicken feed. So she switched from commercial egg production to building a flock in order again to sell chickens for meat. In May 2012, she purchased more than 69 birds, distributed among at least 14 breeds. She sold no chickens in 2012 or 2013 but had plans to begin sales in 2014. Her plans were thwarted when, in January 2014, wild dogs destroyed most of the flock.

When Ms. Legarcie was raising meat chickens, she occasionally sold or bartered excess eggs that she did not need to grow the flock. Ms. Legarcie's only reported income from selling eggs was $1,068 she reported for 2012. Between 2007 and 2011, Ms. Legarcie grew watermelons, squash, peppers, apples, bananas, pomegranates, date palms, and asparagus on the property. She claimed the expenses of growing those crops as farming expense deductions, but she reported no revenues from sales. Her lack of revenue was due to the fact that the property is on the edge of the world's largest evaporative salt plant, and, in 1973, a spill from the salt plant created a salt flat on a portion of the property. Moreover, evaporation from the salt plant blows across the property and poisons the soil. Crops grown on the property are not commercially acceptable.

In 2012, Ms. Legarcie planted a test crop of peppers, which was not successful because insects destroyed the crop. Also in 2012, Ms. Legarcie acquired three cows and three calves. Her plan was to feed them, make them big, and then sell them. However, because the cows couldn't find enough to eat on the property, Ms. Legarcie had to sell them. She sold the cows in 2013 for $4,800, which was the only farm activity income reported for 2013.

For 2012 and 2013, Ms. Legarcie reported on Schedules F the gross income and expenses from her farming activities. She described her principal crop or activity on the schedules as "Poultry Products". For 2012, she reported income of $1,068 from egg sales, and, for 2013, income of $4,800 from the sale of the cows. She also reported related deductions for car and truck expenses, licenses, and depreciation on Schedule C, Profit or Loss from Business.

Ms. Legarcie and Mr. Costello owned several rental properties. They attached Schedule E, Supplemental Income and Loss, to each of their 2012 and 2013 Forms 1040 reporting a net loss of approximately $21,000 from rental real estate for 2012 and rental income of approximately $41,000 for 2013. On those Schedules E, the couple reported that they were real estate professionals who materially participated in a rental real estate activity. On the 2012 Schedule E, they listed four separate properties, and, on the 2013 Schedule E, they listed two of those four properties. One of the properties, located on Silvertip Drive, was flooded sometime in the 2000s and was not thereafter in condition to rent. The couple did not advertise it for rental and reported no rental income for it after 2005. They did, however, deduct losses of approximately $18,000 for 2012 and 2013 relating to that property. Two of the properties were sold in 2012 and the couple reported a long-term capital gain of more than $312,000 from those sales. The couple also claimed deductions relating to their real estate activity on Schedules C for 2012 and 2013.

The IRS disallowed the loss deductions for the farming activity because, it said, Ms. Legarcie's farming losses were not incurred in carrying on a trade or business. According to the IRS, Ms. Legarcie was not entitled to deduct the farming-activity losses under Code Sec. 162 for two reasons: one, she lacked a profit motive, and two, her business had not yet begun during 2012 and 2013. Her business, the IRS contended, had not moved beyond initial research and investigation into an operating business.

The IRS also disallowed the losses taken on the Silvertip Dr. property for both 2012 and 2013 on the grounds that it was not a rental property. The IRS disallowed the remaining 2012 Schedule E loss on the grounds that it was a passive activity loss. However, the IRS allowed the 2012 loss to be carried over to 2013 and claimed against the passive activity income from 2013.

Finally, the IRS also determined that the couple was liable for an addition to tax for failure to file a timely tax return for 2012 and accuracy-related penalties based on negligence and a substantial understatement of income tax for 2012 and on negligence for 2013. Ms. Legarcie and Mr. Costello contested the deficiency and penalty before the Tax Court.

Analysis

The Tax Court agreed with the IRS that Ms. Legarcie's farming activity, notwithstanding her determination to earn a profit from the activity, was for the most part preoperational. For that reason, the court disallowed any loss deductions from that activity. The court noted that, in order for expenses to be deductible under Code Sec. 162(a), the expenses must relate to a trade or business that is functioning when the expenses were incurred. Citing the decision in Richmond Television Corp. v. U.S., 345 F.2d 901 (4th Cir. 1965), the court observed that a taxpayer has not engaged in carrying on any trade or business' within the intendment of Code Sec. 162(a) until such time as the business has begun to function as a going concern and has performed those activities for which it was organized. Instead, the court stated, until the time the business is performing the activities for which it was organized, expenses related to that activity are not currently deductible but are instead classified as startup or pre-opening expenses. Under Code Sec. 195, the court stated, such expenses are deductible over time once an active trade or business begins.

The Tax Court also sustained the IRS's adjustment disallowing the couple's deductions with respect to the Silvertip Dr. property since the property was not in a rentable condition. However, the court noted that the IRS had subsequently conceded that it had erred in determining that for 2012 there was any passive activity loss. In a post-trial conference with the parties, the Tax Court pointed out that, in 2012, Ms. Legarcie and Mr. Costello sold two of their rental properties and reported from those sales a 2012 long-term capital gain of $312,747. The IRS conceded that the amount of gain was part of the couple's aggregate income from passive activities for 2012.

Moreover, because the 2012 aggregate income from passive activities greatly exceeded the year's aggregate losses from passive activities (including the Schedule C (real estate) loss), there was no 2012 passive activity loss. And, for that reason, there was no passive activity loss that could be carried over to 2013. In sum, except for the IRS's Schedule E adjustment disallowing any loss deduction with respect to the Silvertip Dr. property, the court found that the IRS's Schedule E and Schedule C adjustments for both 2012 and 2013 were in error and had to be reversed.

For a discussion of costs that are classified as start-up expenses, see Parker Tax ¶95,710. For a discussion of rental activities subject to the passive activity loss limitation rules, see Parker Tax ¶247,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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