non-profit motivated investor in farming and ranching. It appears likely that most of the concern over the cash method as it is used in agriculture in fact reflects dissatisfaction with tax benefits received by outside investors in unprofitable agricultural ventures, and not dissatisfaction with the cash receipts and disbursements method as it is applied to the ordinary farmer or rancher. [Reprint from December, 1969, issue of the TEXAS LAW REVIEW] A BOUNTIFUL TAX HARVEST CHARLES DAVENPORT* Professor Davenport traces the development of the "farm loss" I. INTRODUCTION The nation's income tax law takes its form from its various architects. Congress has the initial chance to structure it. Then the Treasury promulgates regulations. These sources are subsequently interpreted by the courts in deciding cases and by the Internal Revenue Service in many administrative proceedings. Each institution is undoubtedly reacting to a peculiar set of pressures and to special arguments being exerted at the moment. As a consequence, the law at any time may be something that just happened. It is not surprising that a system growing like Topsey may sometimes reach a topsyturvy result. At this writing, several industries, notably oil and gas, real estate, perhaps timber, and some farming, offer this opportunity. This paper, however, is limited to the "farm loss" problem, but it seems likely that the conclusions and analytic techniques set forth are equally applicable in any case in which premature deductions are allowed for the cost of assets, while also conferring capital gain treatment on the sales proceeds to the extent they exceed any basis the property may have. Thus the conclusions and techniques discussed herein might just as easily apply to depreciation on real estate unless this deduction is sharply reduced by the current tax reform proposals. Acting Professor of Law, University of California at Davis. A.B., 1954, Chico State College; LL.B., 1957, Harvard Law School. 2 TEXAS LAW REVIEW [Vol. 48:1 The "farm loss" problem arises from the deduction of capital costs while allowing sales proceeds to be treated as capital gain. We shall first trace briefly the development of the tax law in agriculture to ascertain just how we got where we are. Then we shall turn to a demonstration of the benefits afforded by the tax law. Thereafter the areas of principal application shall be outlined, and finally some solutions currently proposed will be evaluated. II. GROWTH OF THE TAX HARVEST A. A Seed Is Planted One root of the farm problem lies in a number of administrative decisions made very early in the game. A Treasury Decision1 in 1915 and regulations issued under the Revenue Act of 19162 provided that the farmers could report their income on either the cash or accrual method of accounting. More importantly, the same authority gave the farmers permission to dispense with accounting practices employed by other businesses and permitted them to deduct livestock-raising costs even though they were capital expenditures. This decision seems to have been prompted by several considerations. First, since the identification of specific costs attributable to particular animals on hand at year's end would have been very difficult, the easy answer was to ignore such costs. Furthermore, the accounting principles of the time appear to have been unsophisticated and unprepared to deal with the problem of segregating and capitalizing costs associated with livestock. Finally, there was undoubtedly some notion that the average farm did not represent the type of investment or financial acumen usually found in other business operations. To ask that expensive accounting techniques be employed would not only have overburdened the investment, but would also have overtaxed the farmer's financial management capacity. In a sense, farms were just not considered businesses. These early regulations also addressed themselves to the amounts incurred in the development of orchards and ranches. Contrary to the rule for livestock, the initial regulations required these costs to be capitalized. Presumably, the inconsistency of allowing livestock 1 T.D. 2153, 17 TREAS. DEC. INT. REV. 101 (1915), as amended, T.D. 2665, 20 TREAS. DEC. INT. REV. 45 (1918). 2 Treas. Reg. 33, art. 4 (1917). 3 United States v. Catto, 384 U.S. 102, 110 (1966). 4 Treas. Reg. 33, art. 4 (1917). 1969] "FARM LOSS" TAX REFORM 3 farmers an immediate writeoff while requiring capitalization of development costs of orchards and ranches was raised, and the issue was resolved for deductibility of both kinds of expenses when the next regulations were issued in 1919. Case law stemming from this era indicates that, left to its own devices, the judiciary would have reached contrary results for those development costs. 6 When these liberal rules, the expensing of raising and developing costs, were formulated, they had but one effect on tax liabilities. The deductions were premature and created artificial tax losses, which would not have arisen had the costs been properly capitalized. These artificial tax losses offset income from other sources and permitted a deferral of tax liabilities on other income until the farm assets were sold. This gross mismatching of income and expense could be tolerated when tax rates were relatively low. They became quite another matter when, as later explained, they combined with very high ordinary income rates and lower capital gains rates on many farm assets. The point of recounting the historical is that these liberal accounting rules were developed by an administrative agency under a statute requiring that income be properly reflected. While expediency might be their chief justification, there is nothing to indicate that their impact as a stimulant for investment in farm assets was ever considered. Indeed, that consideration would have been improper. Furthermore, it is doubted that they originally had any such effect; instead, they dealt with difficult accounting problems. B. The Flower Blooms Congress discovered capital assets in the Revenue Act of 1921. It did not see fit, however, to include within that category depreciable property used in the trade or business. We were later told that this property had been excluded in order to assure full deductibility of losses." Whatever the reason for excluding these assets from the preferred treatment, World War II brought forth a rash of condemnations, destructions, and sales of depreciable property that had appreciated substantially. To prevent virtual confiscation of such ap 5 Treas. Reg. 45, art. 110 (1919). 6 See Ribbon Cliff Fruit Co., 12 B.T.A. 13 (1928); Harry B. Hooper, 8 B.T.A. 397 (1927). 7 H.R. REP. No. 2333, 77th Cong., 2d Sess. 53-54 (1942). See Wells, Legislative History of Treatment of Capital Gains Under the Federal Income Tax, 1913-1948, 2 Nat'l Tax J. 12, 31-32 (1949). |