Tax Court decision may create uncertainty for cash-basis taxpayers applying tangible property regulations

Tax Hot Topics: Cash-basis taxpayers and tangible property regsA recent Tax Court case has created some uncertainty for cash-basis taxpayers regarding the treatment of material and supplies under the new final tangible property regulations.

The issue in Agro-Jal Farming Enterprises, Inc. v. Commissioner, 145 T.C. 5 (2015) was the treatment of prepaid materials and supplies by a cash-basis taxpayer under the regulations (Treas. Reg. Sec. 1.162-3) that were in effect before the final tangible property regulations in T.D. 9636 (which are generally effective for materials and supplies incurred for taxable years beginning on or after Jan. 1, 2014).

Agro-Jal is a farming business that uses the cash method of accounting for income tax but the accrual method of accounting for its financial statements. The business kept physical inventories of its field-packing materials and recorded the unused portion in a balance sheet account for financial statement purposes. For tax purposes, Agro-Jal expensed the full amount of field-packing materials when paid.  

The Tax Court held the field-packing materials were not included in types of supplies subject to Section 464, which specifically deals with certain prepaid supplies such as feed, seed and fertilizer used in a farming business. Therefore, the court held the supplies were subject to Treas. Reg. Sec. 1.162-3.  

Treas. Reg. Sec. 1.162-3 (as it was written in the years at issue) stated that “[t]axpayers carrying materials and supplies on hand should include in expenses the charges for materials and supplies only in the amount that they are actually consumed and used in operation during the taxable year for which the return is made, provided that the costs of such materials and supplies have not been deducted in determining the net income or loss or taxable income for any previous year” (emphasis added).  The court’s holding hinged on the emphasized language, which isn’t included in the final tangible property regulations.

The IRS argued that Agro-Jal must defer its deductions for field-packing materials until used or consumed. Agro-Jal argued that the emphasized language cited previously means it has to defer its deductions until it uses or consumes the field-packing materials “only if” it didn’t deduct them in any prior year. As a cash-method taxpayer, it will always have deducted the prepaid materials in the prior year because that’s when the business paid for them. The Tax Court agreed with Agro-Jal that for a cash-basis taxpayer, the prepaid supplies are deductible when paid.

The emphasized language, however, was removed in the final tangible property regulations. Based on the preamble to prior proposed tangible property regulations, as well as public statements from the government, it appears the government didn’t intend for the revisions to be a substantive change in the treatment of materials and supplies as either nonincidental or incidental. For example, see the preamble to the proposed regulations (REG-168745-03). However, while the Tax Court’s decision provides certainty for years before the new regulations, the court’s reliance in this case on the subsequently deleted language generates uncertainty for all cash method taxpayers regarding the treatment of prepaid supplies for taxable years in 2014 and forward.

Sharon Kay
+1 202 861 4140

Ellen Martin
+1 202 521 1558

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