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Letter Ruling 9818006, January 6, 1998

Uniform Issue List Information:
UIL No. 0162.01-11
Trade or business (deductible v. not deductible)
- Trade or business v. not a trade or business
-- Farming
UIL No. 0162.18-00
Trade or business (deductible v. not deductible)
- Farmers

Code Sec. 162

ISSUE:

Whether Taxpayers may deduct the purchase price of trees pursuant to §1.162-12 of the Income Tax Regulations.

CONCLUSION:

The costs of purchasing the trees in this case are deductible by Taxpayers in the taxable year of purchase pursuant to §1.162-12 .

FACTS:

Taxpayers are engaged in the nursery business of selling trees with a three inch to eight inch diameter trunk. Taxpayers began their nursery operation in Year One. Trees purchased by Taxpayers are bare root trees, as opposed to container grown trees or trees removed from the ground with a dirt ball attached to the root system. The cost of the trees ranged from $7 to $23. The trees purchased are generally one to two years old at the time of purchase.

Bare root trees are trees that are removed from the ground with no soil attached to the roots. They are refrigerated in a dormant state until their sale to a commercial grower or nursery and then shipped via refrigerated truck. The trees are then "trenched" in mulching medium and kept moist until such time as the trees can be planted into the ground for further growth and cultivation. Taxpayers represent that this method of removal from the ground causes the trees to lose a portion of their root system and, as a result, the trees require special care prior to and just after planting. The survival rate of such bare root trees after transplanting is considerably lower than that of trees that are transplanted with their roots undisturbed. For this reason, Taxpayers represent that bare root trees are not ready for resale to the general public in retail nursery operations after purchase. The advantage to Taxpayers of purchasing these types of bare root trees is that bulk quantities of the trees can be shipped more easily and in a less costly manner than transplanted trees, which results in a lower purchase cost to Taxpayers.

Many of the trees purchased by Taxpayers are known as "whips" in the nursery industry. A "whip" is essentially a stick with attached roots and no branches. All of the trees purchased by Taxpayers are grown by Taxpayers for a minimum of five years before their ultimate sale. At the time of ultimate sale, the trees are sold with the dirt ball attached in contrast to the bare root trees that are originally purchased. New bare root trees are purchased annually to replenish trees that were sold or that did not survive.

Many of the trees purchased by Taxpayers do not resume growing for more than a year and many trees do not survive. Taxpayers represent that their business is not to maintain an inventory of trees for immediate sale, but rather to grow the trees to a larger size and then sell them for an increased price more than five years after initial purchase.

For Year Two, Taxpayers reported gross receipts of $c and deducted the cost of trees purchased in the amount of $d. Taxpayers do not use the crop method of accounting and, pursuant to §263A(d)(3) , have properly elected to have the cost capitalization rules of §263A not apply to any trees grown in their nursery business.

LAW:

Section 162(a) of the Internal Revenue Code provides a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 1.162-1 provides that deductible business expenses include ordinary and necessary expenditures directly connected with or pertaining to the taxpayer's trade or business, except items that are used as the basis for a deduction or a credit under other Code sections.

Section 1.162-12(a) provides, in relevant part, as follows:

"A farmer who operates a farm for profit is entitled to deduct from gross income as necessary expenses all amounts actually expended in the carrying on of the business of farming .... If a farmer does not compute income upon the crop method, the cost of seeds and young plants which are purchased for further development and cultivation prior to Sale in later years may be deducted as an expense for the year of purchase, provided the farmer follows a consistent practice of deducting such costs as an expense from year to year. The preceding sentence does not apply to the cost of seeds and young plants connected with the planting of timber (see section 611 and the regulations thereunder)."

Section 263A(a)(1) and (2) provides, in part, that, in the case of any property to which this section applies, the direct costs of the property and the property's proper share of those indirect costs which are allocable to the property shall be capitalized. Section 263A(d)(3)(A) provides that a taxpayer carrying on any farming business may elect out of §263A with respect to any plant produced in that business. Section 263A(d)(3)(D) provides that such election may be made only for the taxpayer's first taxable year that begins after December 31, 1986, and during which the taxpayer engages in a farming business. This election may be revoked only with the Secretary's consent.

Section 263A(e)(2)(A) provides in relevant part that, if the taxpayer makes an election under §263A(d)(3) , the provisions of §168(g)(2) (relating to the alternative depreciation system) shall apply to all of the taxpayer's property used predominantly in the farming business and placed in service in any taxable year during which any such election is in effect.

ANALYSIS:

The costs at issue in Taxpayers' case all relate to the purchase price of one to two year old trees that require significant development and cultivation by Taxpayers after purchase. To determine whether capitalization of such purchase costs is warranted, or whether Taxpayers may deduct such costs as ordinary and necessary trade or business expenses, one must consider the general purpose of §1.162-12 .

The purpose of §1.162-12 is to give farmers the option of deducting or capitalizing expenditures incurred in the preproductive period that bear characteristics of both capital outlays and ordinary expenses and, as such, fall within a "band of gray." See Hodel v. Commissioner, T.C. Memo. 1996-348 [CCH Dec. 51,475(M) ] (quoting Estate of Wilbur v. Commissioner, 43 T.C. 322, 327 (1964)) [CCH Dec. 27,080 ]. Subject to certain limitations, the Code and regulations are designed, therefore, to give taxpayers a choice between capitalization or deductibility of such costs. The mechanism for exercising this choice is contained in §263A(d)(3) , which permits certain farmers to elect not to capitalize costs such as the costs at issue in this case. The revenue agent has indicated that Taxpayers properly elected out of the cost capitalization rules outlined in §263A .

The revenue agent's position is that the trees at issue in the instant case do not qualify as "seeds and young plants" within the meaning of §1.162-12 . The revenue agent refers in his report to Industrial Agrigrowth Consulting Services, Inc. v. Commissioner, T.C. Memo. 1988-382 [CCH Dec. 44,986(M) ], as the most recent case concerning this issue. However, the court in Industrial Agrigrowth held merely that petitioner failed to establish as a factual matter that its ornamental trees qualified as "young plants" within the meaning of §1.162-12 . The record in Industrial Agrigrowth provided little specific information regarding the maturity or marketability of the trees at the time of purchase by petitioner. To the contrary, based on representations provided by Taxpayers and the facts developed by the revenue agent, the trees in the instant case are all relatively young at the time of purchase (one to two years old) and are cultivated and developed for at least five years before the trees are marketed. Moreover, Taxpayers represent that the trees require special care due to the bare root method of extracting the trees from the ground initially and, as a result, these types of trees have considerably lower survival rates than trees that are transplanted with their roots undisturbed.

Because Taxpayers in this case have elected under §263A(d)(3) not to be subject to the capitalization rules of that section, and because the trees at issue require significant development and cultivation on Taxpayers' part to ensure survival and future marketability, we believe the trees are within the purview of the treatment accorded "seeds and young plants" under §1.162-12 . Accordingly, the cost of the trees is deductible by Taxpayers in the taxable year of purchase pursuant to §162 and 1.162-12 .

A copy of this technical advice memorandum is to be given to the taxpayers. Section 6110(j)(3) of the Code provides that it shall not be used or cited as precedent.