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Rancher's Ownership History Is Antithesis of Farming Syndicate; Cash Method Allowed.
(Parker Tax Publishing June 8, 2014)

In a case of first impression, the Fifth Circuit rejected IRS attempts to label a long-time rancher as a farming syndicate solely because she owned her ranch through an S corporation. Burnett Ranches, Ltd. v. U.S., 2014 PTC 249 (5th Cir. 5/22/14).

Generally, farming syndicates are prohibited by Code Sec. 464 (acting in conjunction with Code Sec. 448) from using the cash method to deduct amounts paid for feed, seed, fertilizer, or other similar farm supplies. Instead, such deductions are only allowed in the tax year these items are consumed or used. Section 464 was enacted to close a tax loophole that involved limited partnerships and similar investment entities acquiring interests in agricultural trades or businesses that had large tax operating losses, as a result of expensing costs under the cash method for things like supplies and feed, then selling fractional interests in those entities to sophisticated passive investors. Those passive investors, who had nothing to do with farming, generally had large taxable incomes and would offset their respective shares of the farm's tax losses against their unrelated taxable incomes. In response, Congress enacted Code Sec. 464. However, Congress carved out exceptions to this rule that allow individuals, families, and entities legitimately and directly engaged in agricultural enterprises to use the cash method.

In Burnett Ranches, Ltd. v. U.S., 2014 PTC 249 (5th Cir. 5/22/14), the IRS tried to limit the application of these exceptions in the case of a rancher who wholly owned a farm through an S corporation. While admitting that the rancher actively participated in the management of the agricultural business for the required period of time and that her interest in the ranch was attributable to her active participation, the IRS's sole basis for pursuing her for millions of dollars of additional taxes was that the rancher owned her ranch through an S corporation rather than owning it directly, thus it was a farming syndicate tax shelter. Therefore, the IRS argued the farming business was required to use the accrual method. The Fifth Circuit, noting that this was a case of first impression, applied common sense and rejected the IRS's assertion.


Anne Marion is a member of the Burnett family. She oversees and manages the family's cattle and horse breeding operations, which are conducted principally on two Texas ranches that have been owned by her and her predecessors for generations the 6666 Ranch (Four Sixes Ranch) and the Dixon Creek Ranch. The former has been a stereotypical Texas working livestock ranch for more than 150 years and has been operated continuously by a series of direct descendants of Captain S. B. Burnett, who founded the Four Sixes Ranch sometime between the fall of the Alamo and the beginning of the Civil War. The most recent operator is Anne. Years ago, she was designated Operations Manager of Burnett Ranches' entire ranching business. She is the sole owner of the Four Sixes Ranch, where some aspects of Burnett Ranches' livestock business are conducted, and she is a half owner, individually and through the Tom L. and Anne W. Burnett Trust (the TLAB Trust) of Dixon Creek Ranch, a limited partnership, where other facets of that business are conducted.

Burnett Ranches filed its tax return under the cash method of accounting. However, the IRS determined that it could not use the cash method for 2005, 2006, and 2007, because it was a tax shelter under Code Sec. 448 by virtue of being a "farming syndicate" under Code Sec. 464. Moreover, Burnett Ranches had reported farming deductions using the cash method for amounts paid for farm supplies in those years. As a result, the IRS said it had to use the accrual method. This resulted in higher than reported taxable income for the tax years in question.

Farming Syndicates and the Active Participation Exception

Code Sec. 448 states that the cash method of accounting is not permitted for C corporations, partnerships that have a C corporation as a partner, or tax shelters. Although there is an exception in subsection (b) for farming business, the exception does not apply to tax shelters. Tax shelters are further defined in the section as having the meaning under Code Sec. 461(i)(3), and under subsection (i)(4), farming syndicates are implicated.

Under Code Sec. 464(c)(1)(B), a farming syndicate includes a partnership or any other enterprise (other than a corporation that is not an S corporation) engaged in the trade or business of farming, if more than 35 percent of the losses during any period are allocable to limited partners or limited entrepreneurs. Code Sec. 464(c)(2)(A) excludes from this definition any interest in a partnership or other enterprise held by an individual as a limited partner or a limited entrepreneur where the individual has actively participated for a period of not less than five years in the management of any trade or business of farming.

Lastly, Code Sec. 464(a) provides that, in the case of any farming syndicate, a deduction otherwise allowable for amounts paid for feed, seed, fertilizer, or other similar farm supplies are allowed only for the tax year in which such feed, seed, fertilizer, or other supplies are actually used or consumed, or, if later, for the tax year for which allowable as a deduction.

Burnett Ranches' Position

Burnett Ranches' position was that because Anne had "actively participated" in the management of the ranching business for more than five years before the years at issue, her interest in the company was attributable to her management, qualifying the company for the exception in Code Sec. 464(c)(2)(A).

IRS Argument

The IRS rejected the argument that Anne qualified for the active participation exception in Code Sec. 464(c)(2)(A). According to the IRS, by holding her share of Burnett Ranches in the name of an S corporation, Anne was prevented from qualifying for the active participation exception because the term "any interest" in that provision had to be narrowly construed as synonymous with legal title or direct ownership.

District Court Holding

In district court, the IRS agreed that Anne met the requirement for active participation in management but still insisted that, because of the structuring of Anne's ownership interest, the partnership was required to use the accrual method of accounting. The district court rejected the IRS's claim and held for Burnett Ranches because of the IRS's concession on the question of active participation. The IRS appealed to the Fifth Circuit.

Fifth Circuit's Analysis

In its analysis, the Fifth Circuit considered whether Anne's indirect interest in Burnett Ranches through an S corporation would negate the ranches from otherwise qualifying for the active participation exception. The court reviewed the purpose of Code Sec. 464, which was intended to close a loophole of allowing taxpayers with sizable taxable incomes to take advantage of the business' high losses. The court then looked at the exception contained in Code Sec. 464(c)(1)(A) and noted that Congress expressly provided that any interest in an agricultural venture that is "attributable to" an individual's "active participation" in the "management" of the farming activity for more than five years is not to be treated as the interest of a proscribed limited partner or limited entrepreneur. Importantly, the court stated, Congress did not restrict this particular exception to interests of which such an actively participating manager holds legal title in his or her name.

Burnett Ranches, the court observed, was the exact opposite of the type of tax-motivated operation Congress contemplated when drafting Code Sec. 464, because Anne, her family, and Burnett Ranches had been continuously engaged in the agricultural business for over 150 years. Further, the court noted that Anne had been the lead operator of one of the ranches and a half owner/operator of the other for more than the five years required for the active management exception to the tax shelter rule. The court held that Anne had a bona fide interest notwithstanding the business structure and noted that the business structure provided her with no tax benefits.

The court stressed that the business and ownership history of these ranches and their operations was the very antithesis of the "farming syndicate" tax shelters that Code Sec. 464 was enacted to thwart. In fact, the court said, Anne and her family's uninterrupted history with the farming operations and the lands on which they are conducted could be the poster child for Congress's inclusion of the active participation exception in Code Sec. 464 to exempt such entities and their substantial hands-in-the-dirt owners and operators from that provision's reach. (Staff Editor Parker Tax Publishing)

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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