Agro-Jal Farming Enterprises, Inc. is a family owned farming corporation that produces strawberries and vegetables (the “Taxpayer”). The Taxpayer deducted the amounts paid for the packing materials in the year they were purchased even though they were not used until the following year. The IRS claimed that the Taxpayer was entitled only to deduct the cost of the materials in the tax year used. In a case of first impression, the Tax Court concluded that the cost of the packaging materials could be deducted in the year purchased. The controlling Regulation Section was Treasury Reg. Sec. 1.162-3 which states:
“Taxpayers carrying materials and supplies on hand should include an expenses that charges for such materials and supplies only an amount that they are actually consumed and used in operations during the taxable year for which the year return is made, provided that the cost of such materials and supplies has not been deducted in determining the net income or loss or taxable income for any previous year”.
The Taxpayer argued that since the cost of materials and supplies had been deducted in determining net income for a prior year, the first part of the Regulation was inapplicable. The Taxpayer argued that the second part of the Regulation (in bold print) requires that if a Taxpayer had not deducted the expenses in a prior year then they can only deduct them in the year used. The IRS argued that “provided that” should be read “in lieu of” and therefore the Taxpayer can only deduct the cost of the packing materials in the year used. The Tax Court determined that “provided” means “on the condition that” or “if” and held that the “provided that” clause of the Regulation Section means that materials and supplies must be deducted as they are used or consumed only if they have not been deducted in a prior year. If a Taxpayer immediately deducts a present year purchase it satisfies the first part of Reg. Sec. 1.162-3 by not taking the second deduction when the materials and supplies are used in a later taxable year.
It should be noted that the supplies must be used within one year of purchase or otherwise they may have to be capitalized.
Farmers have routinely been expensing supplies for many years and it is surprising that this is the first time the IRS challenged such deductions in Court.
The years in issue in the Agro-Jal case were 2005 – 2008. The language in Reg. Sec. 1.162-3 that the Court emphasized (“provided…) in the regulations in effect at that time was removed in the final tangible property regulations. It would appear that the IRS may challenge a cash basis farmer’s ability to deduct supplies when purchased under the new regulations and if that is the case, the Agro-Jal Farming Enterprises, Inc. case will not provide much comfort.
Michael A. Kulzer is the founding shareholder of the firm and earned his J.D. degree at the Rutgers University School of Law, where he was awarded the Prentice Hall Award for outstanding performance in the area of taxation. He earned his LL.M. in Taxation at New York University. Mr. Kulzer’s particular areas of expertise include estate planning, corporate taxation and business planning.