IRS PROVIDES OPTIONAL SIMPLIFIED METHODS FOR APPLYING UNIFORM CAPITALIZATION RULES TO BEEF AND DAIRY CATTLE.

Notice 88-24

This notice provides guidance to taxpayers regarding the application of the uniform capitalization rules to property produced in the trade or business of farming. In addition to a discussion of the general application of the rules, this notice provides safe- harbor values that are available to certain taxpayers with respect to cattle produced in a farming business.

BACKGROUND

Section 263A of the Internal Revenue Code, enacted by the Tax Reform Act of 1986 (Pub. L. 99-514) (the "1986 Act"), provides uniform capitalization rules that apply to the production of property and the acquisition of property for resale. Under those rules, all direct and indirect costs that are allocated to production and resale activities are required to be capitalized by the taxpayer. Capitalized costs are then accounted for by the taxpayer under the various rules contained in the Code regarding the recover of costs (depreciation, cost of goods sold, etc).

Section 263A generally applies to the production, growing or raising of property in the trade or business of farming if such property (i) has a preproductive period of more than 2 years ("2-year property"); or (ii) is produced by a corporation, partnership, or tax shelter required to use an accrual method of accounting under section 447 or 448 of the Code. (See section 1.263A-1T(c) of the regulations for further guidance regarding these rules). Section 263A generally applies to costs incurred by the taxpayer after December 31, 1986, in taxable years ending after such date.

Section 1.263A-1T(c)(ii) of the regulations, consistent with the legislative history of the Act, provides that in the case of an animal the preproductive period (i) begins at the time of the animal's acquisition, breeding, or embryo implantation, and (ii) ends when the animal becomes productive in marketable quantities or when the animal is reasonably expected to be sold or otherwise disposed of. For example, in the case of a cow raised by a farmer to be used for breeding or dairy purposes, the preproductive period of the cow begins with its conception and ends on the date that the cow drops its first calf. Accord, H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 628 (1985).

Taxpayers may use reasonable assumptions and estimates in determining whether animals produced in a farming business have a preproductive period of more than 2 years. For example, assume a taxpayer raises cattle that may be either sold by the taxpayer before the end of the 2-year preproductive period, or alernatively, kept by the taxpayer beyond the 2-year period.

Assume also that the taxpayer is not required to use an accrual method of accounting under section 447 or 448, and thus the taxpayer is required to capitalize costs under section 263A only with respect to cattle with a preproductive period of more than 2 years. In determining the cattle that have a preproductive period of more than 2 years, the taxpayer may reasonably estimate, based on past experience and other factors, the percentage of total cattle raised that are reasonably expected to be kept beyond the 2-year period; the proviions of section 263A would then apply to these cattle. Similar estimates may be made by the taxpayer with respect to the sex of cattle that are conceived, but not yet born as of the end of the taxable year.

COSTS TO BE CAPITALIZED

Taxpayers capitalizing costs under section 263A (using the unit livestock method or any other method) must capitalize all direct and indirect costs allocable to the farming property being produced. Costs that are allocable to property being produced include both variable costs that directly correspond to the volume of the taxpayer's production (such as feed), as well as fixed costs which generally do not increase in proportion to the volume of the taxpayer's production (such as depreciation on machinery). Thus, costs required to be capitalized under section 263A are not limited to "marginal" increases in costs attributable to the property being produced, but rather also include portions of fixed costs which are not marginal in nature.

With respect to cattle, costs typically required to be capitalized under section 263A will include the costs of feed (such as grain, silage, concentrates, supplements, haylage, hay, pasture and other forages), breeding, artificial insemination, veterinary services and medicine, livestock hauling, bedding, fuel, lubrication and electricity, hired labor (where applicable), tax depreciation and repairs on buildings and equipment used in raising the cattle (for example, barns, trucks and tractors), farm overhead, taxes relating to any of these items (except for State and Federal income taxes), and interest relating to any of these items (determined, where applicable, under the "avoided cost" method as described in section 1.263A-1T(b)(2)(iv) of the regulations).

In light of the additional costs required to be capitalized under section 263A, taxpayers should not adopt unit prices utilized in the past under the unit livestock method without carefully analyzing whether these unit prices reflect all of the costs required to be capitalized by the particular taxpayer under section 263A.

METHODS AVAILABLE

Certain taxpayers, other than those required to use an accrual method of accounting, may elect not to have the rules of section 263A apply with respect to certain types of property produced in the trade or business of farming. See section 1.263A-1T(c)(6) of the regulations. Taxpayers making the election may (subject to other limitations of the Code) continue to deduct the costs that were deductible under the rules in effect before the enactment of section 263A of the Code.

With respect to taxpayers that do not make the election out of section 263A, section 1.263A-1T(c)(5) of the regulations generally provides that the costs required to be capitalized with respect to farming property may, if the taxpayer chooses, be determined using reasonable inventory valuation methods such as the farm-price method or the unit livestock method. The use of these inventory valuation methods avoids the necessity of accounting for the costs of raising animals by "tracing" and accumulating costs applicable to each separate animal. In addition, under the regulations, these inventory methods may be used by a taxpayer regardless of whether the farming property being produced is otherwise treated as inventory by the taxpayer, and regardless of whether the taxpayer is otherwise using the cash method or an accrual method of accounting. Thus, for example, the unit livestock method may be utilized by a taxpayer in accounting under section 263A of the Code for the costs of raising animals that will be used for draft, breeding or dairy purposes and depreciated (under the rules of section 168 of the Code) when the animal is placed in service.

Notwithstanding a taxpayer's use of the farm-price method or the unit livestock method with respect to farm property to which the provisions of section 263A apply, that taxpayer is not required, solely by such use, to use the same method of accounting with respect to farming property to which the provisions of section 263A do not apply. Thus, for example, assume that Farmer A raises dairy cattle to which the provisions of section 263A apply, as well as cattle that are fed and held primarily for slaughter. Assume also that Farmer A is not a taxpayer required to use an accrual method of accounting under section 447 or 448; thus the provisions of section 263A do not apply to the cattle held by Farmer A primarily for slaughter. (See section 1.263A-1T(c)(1) of the regulations.) Although Farmer A may use the unit livestock method with respect to the dairy cattle, his use of this method does not require Farmer A to use the unit livestock method with respect to the cattle held primarily for slaughter. Instead, Farmer A's accounting for such slaughter cattle is determined under other provisions of the Code and regulations thereunder.

UNIT LIVESTOCK METHOD

Taxpayers not electing to use the safe harbors provided in this notice may use any reasonable inventory valuation method to capitalize the costs of producing property in the trade or business of farming under section 263A. One such reasonable inventory valuation method is the unit livestock method, described in section 1.471-6 of the regulations. Under the unit livestock method, the taxpayer adopts a standard unit price for each animal within a particular class; this standard unit price is used by the taxpayer in lieu of specifically identifying and tracing the costs of raising each animal in the taxpayer's farming business. Taxpayers using the unit livestock method must adopt a reasonable method of classifying animals with respect to their age and kind so that the unit prices assigned by the taxpayer to animals in each class are reasonable. Thus, taxpayers using the unit livestock method typically classify cattle based on their age (for example, a separate class will typically be established for calves, yearlings and 2-year olds).

Under section 1.471-6 of the present regulations, taxpayers using the unit livestock method may not subsequently change the classification or unit costs they initially adopted without obtaining the approval of the Commissioner. (Taxpayers who were, however, using the unit livestock method prior to the effective date of section 263A are required to change automatically their method of accounting, including their unit costs, to reflect the additional costs required to be capitalized under section 263A. See section 1.263A-1T(e)(11) of the regulations.) Forthcoming regulations will modify this rule contained in section 1.471-6 and require that taxpayers adjust the unit prices upward, from time to time as specified by those regulations, to reflect increases in costs taxpayers experience in raising livestock. Any other changes in the classification or unit prices used in the unit livestock method will continue to be allowed only with the consent of the Commissioner.

In addition, section 1.471-6 of the current regulations provides that no increase in unit cost is required under the unit livestock method with respect to the taxable year in which certain animals are purchased, if such purchases occur in the last six months of the taxable year. The temporary regulations under section 263A, published in the Federal Register on March 30, 1987, (52 FR 10052, T.D. 8131) amend this rule and provide that any tax shelter required to use an accrual method of accounting under section 448 must include in inventory the annual standard unit price for all animals purchased during the taxable year, regardless of when in the taxable year such purchases are made. See section 1.263A-1T(c)(5)(ii) of the regulations. Forthcoming regulations will further amend this rule, and require that all taxpayers using the unit livestock method must modify the annual standard price in order to reasonably reflect the particular period in the taxable year in which purchases of livestock are made, if such modification is necessary in order to avoid significant distortions in income that would otherwise occur through operation of the unit livestock method. Such amendments will be effective for taxable years beginning after December 31, 1987. The regulations will not specify the particular modification that shall be made to the annual standard price for any particular taxpayer, but rather shall allow any reasonable modification made by the taxpayer to the annual standard price to avoid significant distortions in income. For example, assume a taxpayer purchases and raises cattle for slaughter. Assume further that the taxpayer is required to use an accrual method of accounting under section 447 of the Code; thus, section 263A applies to the taxpayer's costs of raising the cattle. Under the forthcoming regulations, the taxpayer may not expense the costs of raising cattle that are purchased in the latter half of the taxpayer's taxable year. Instead, the taxpayer must modify the annual standard price so as to reasonably capitalize the costs of raising the cattle, based on the date of their purchase.

UNIT LIVESTOCK METHOD -- SAFE-HARBOR

The legislative history to the 1986 Act evidences a Congressional concern with the potential complexities imposed on farmers under the uniform capitalization rules. In this regard, the discussion of the uniform capitalization rules in the House Ways and Means Committee Report provides that farmers "may determine the costs required to be capitalized by using methods similar to one of the simplified valuation rules of present laws (e.g., the farm-price or the unit-livestock method), in lieu of capitalizing actual costs". H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 629 (1985). See also S. Rep. No. 99-313, 99th Cong., 2d Sess. 142 (1986).

In addition, the temporary regulations provide simplified methods of complying with section 263A of the Code. The preamble accompanying those regulations stated that the "regulations provide a simplified method for producers of property in order to reduce the administrative costs of taxpayer compliance with the capitalization requirements of section 263A while preserving the statute's basic purpose to apply uniform capitalization rules to the costs of producing property. The Internal Revenue Service welcomes comments and suggestions as to how the simplified production method may be improved to accomplish those objectives most adequately." 52 FR at 10057. In response to this request for comments, several persons have submitted suggestions to the Internal Revenue Service urging the Service to provide for additional simplified methods that would be available to farmers complying with section 263A of the Code.

Based on the foregoing, this notice provides two elective safe harbors that may be used by certain taxpayers in conjunction with the unit livestock method in complying with the capitalization rules of section 263A. Such taxpayers may, at their election, use the safe harbor figures provided in this notice in lieu of independently determining (based on all the applicable facts and circumstances) the amount and timing of section 263A costs to be capitalized with respect to livestock under the unit livestock method or under any other reasonable method.

The safe harbors provided in the notice pertain to the costs of female cattle (to which the provisions of section 263A otherwise apply) raised or purchased by the taxpayer to be used principally (i) for purposes of breeding ("beef cattle"); or (ii) for purposes of producing milk to be sold for consumption ("dairy cattle"). The Internal Revenue Service is aware that the amount and timing of costs to be capitalized under section 263A with respect to beef and dairy cattle may vary depending on the business operations of the particular taxpayer and various other facts. Thus, no inference is intended by the provision of these safe harbors as to the amount and timing of costs to be capitalized by taxpayers not electing the safe harbors provided herein.

The Treasury Department, from time to time, will adjust the safe harbors provided herein to reasonably reflect changes in the costs of producing cattle due to general fluctuations in price indexes and other factors. Any such revisions of these safe harbors will be published by the Internal Revenue Service and will apply to all taxpayers using the safe harbors for taxable years beginning after the date such revisions are published.

RAISED CATTLE.

Taxpayers electing the use of the safe harbor for beef cattle shall capitalize (and decrease the amount of otherwise deductible expenses incurred by the taxpayer) a total of $340 per cow over the following periods: (i) $85 (one-quarter) shall be capitalized in the taxable year in which the cow is born; (ii) $170 (one-half) shall be capitalized in the taxable year following the year in which the cow is born; and (iii) $85 (one-quarter) shall be capitalized in the second taxable year following the year in which the cow is born.

Taxpayers electing the use of the safe harbor for dairy cattle shall capitalize (and decrease the amount of otherwise deductible expenses incurred by the taxpayer) a total of $540 per cow over the following periods: (i) $135 (one-quarter) shall be capitalized in the taxable year in which the cow is born; (ii) S270 (one-half) shall be capitalized in the taxable year following the year in which the cow is born; and (iii) $135 (one-quarter) shall be capitalized in the second taxable year following the year in which the cow is born.

The provisions of these safe harbors apply regardless of when, in the taxable year, the cattle are actually born. Thus, for example, the requirement to capitalize $85 with respect to a beef cow for the first year it is born applies regardless of whether that cow is born in the spring or the fall of the year in question.

In addition, the safe harbors provided in this ruling apply to cattle that were born before January 1, 1987. Assume, for example, that a cash-method farmer raising beef cattle elects to use this safe harbor for his taxable year beginning January 1, 1987. With respect to cattle on hand as of the end of the farmer's taxable year ending December 31, 1987 to which the provisions of section 263A apply, the farmer would capitalize: (i) $85 for each cow born in 1985; (ii) $170 for each cow that was born in 1986; and (iii) $85 for each cow that was born in 1987. For the farmer's 1988 taxable year: (i) no additional amounts would be included in inventory with respect to cows born in 1985; (ii) $85 would be capitalized for each cow born in 1986: (iii) $170 would be capitalized for each cow born in 1987; and (iv) $85 would be capitalized for each cow born in 1988.

PURCHASED CATTLE.

In some situations, the provisions of section 263A may apply to taxpayers who purchase beef or dairy cattle from other persons and then raise such cattle to maturity. Taxpayers electing the safe harbors provided in this notice shall treat the date of the cow's purchase as the date of its birth and shall capitalize the greater of (i) the purchase price of such cattle or (ii) the safe harbor amounts provided herein. Thus, for example, assume a taxpayer purchases a beef calf for $40 in 1987. A taxpayer electing the safe harbor for beef cattle would capitalize $85 (the greater of $40 or $85) with respect to the calf for that taxable year. (This treatment would apply regardless of whether the calf was purchased in the first or second half of 1987). Assume, in contrast, that the taxpayer purchases a beef calf for $95. In that case, the taxpayer would capitalize $95 with respect to that calf for that taxable year. The additional amounts capitalized with respect to the calf for subsequent years would follow the schedule applicable to raised cattle, set forth above (i.e., $170 in the second year and $85 in the third year).

ELECTION TO USE SAFE-HARBORS

The safe harbors provided in this ruling may not be used by any corporation, partnership or tax shelter required to use an accrual method of accounting under section 447 or 448. All other taxpayers to which the provisions of section 263A apply may adopt these safe harbors, subject to the requirements of this notice. Taxpayers eligible to use these safe harbors may automatically elect to use them for the first taxable year in which they raise beef or dairy cattle to which the provisions of section 263A apply. Thus, for example, a farmer raising beef or dairy cattle to which the provisions of section 263A apply may automatically elect to use these safe harbors for his first taxable year ending after December 31, 1986 (typically, the calendar 1987 taxable year). Similarly, with respect to a taxpayer who does not raise beef or dairy cattle to which the provisions of section 263A apply until a later year (for example, 1989), that taxpayer may automatically elect the use of these safe harbors for that later year (1989). Taxpayers may elect the use of these safe harbors by using the safe harbor in determining and reporting their taxable income on a timely filed (with regard to extensions) Federal income tax return for the year in question.

Taxpayers electing the safe harbors provided in this notice may not discontinue the use of such safe harbors unless consent to such change in method of accounting is obtained from the Commissioner. In addition, except as otherwise provided in this notice, taxpayers may not elect or adopt the use of these safe harbors unless consent to such change in method of accounting is obtained from the Commissioner.

TAXPAYERS THAT ELECTED NOT TO HAVE SECTION 263A APPLY FOR 1987.

Taxpayers producing beef or dairy cattle that elected under section 263A(d)(3) of the Code and 1.263A-1T(c)(6) of the regulations not to have the rules of section 263A apply to the costs incurred in a farming business for their first taxable year ending after December 31, 1986, may effectively revoke such election and adopt the use of the safe-harbors provided in this notice (in addition to applying the rules of section 263A to all other applicable plants or animals produced by the taxpayer in a farming business). Taxpayers may revoke the election with respect to their beef or dairy cattle by applying the rules contained in this notice for their taxable year ending in 1987 and by filing an amended return for such year within 180 days after this notice is published in the Internal Revenue Bulletin. Taxpayers that elected under section 263A(d)(3) of the Code not to have the rules of section 263A apply may automatically revoke such election under this notice only for their taxable year ending in 1987 (typically, their calendar year).

TAXPAYERS THAT APPLIED THE RULES OF SECTION 263A FOR 1987.

Taxpayers who applied the rules of section 263A by using reasonable methods (other than the safe harbors provided herein) to capitalize the costs of producing cattle for their first taxable year ending in 1987 may elect the use of the safe harbors provided by this notice for (i) their taxable year ending in 1987, or (ii) their taxable year ending in 1988. (For purposes of this notice and section 263A of the Code, in order for a method to be reasonable, a taxpayer must determine the costs to be capitalized based on the particular facts and circumstances of the taxpayer's operations, and not, for example, on the basis of any "safe harbor" other than the safe harbors provided in this notice.) Taxpayers that elect to apply the use of the safe harbors provided in this notice for their taxable year ending in 1987 shall effect such election by filing an amended Federal income tax return for their taxable year ending in 1987 within 180 days after this notice is published in the Internal Revenue Bulletin.

Taxpayers that do not wish to apply the safe harbors until their 1988 taxable year shall apply the safe harbors provided in this notice to the costs of raising cattle in their 1988 taxable year, while adding such safe harbor costs to the costs capitalized under other reasonable methods for their 1987 year. For example, assume a calendar year taxpayer adopted the unit livestock method and applied the rules of section 263A to beef cattle raised by such taxpayer in 1987 by capitalizing x dollars for each cow born in 1987, y dollars for each cow born in 1986 and z dollars for each cow born in 1985. A taxpayer electing these safe harbor rules for 1988 would capitalize an additional $170 with respect to each cow born in 1987 and on hand at December 31, 1988; thus, each cow would have total accumulated capitalized costs of $170 plus x dollars. Similarly, the taxpayer would capitalize an additional $85 dollars with respect to each cow born in 1986 and on hand at December 31, 1988; such cattle would have total accumulated capitalized costs of $85 plus y dollars. Finally, the taxpayer would capitalize $85 with respect to each cow born in 1988 and on hand at December 31, 1988. For all future years, the taxpayer would capitalize costs based on the safe harbor provided in this notice. Taxpayers may utilize the provisions of this paragraph allowing a change to the safe harbors provided in this notice from other reasonable methods of capitalizing costs only for their taxable year ending in 1988. The provisions of this paragraph may not be used for any later taxable year, nor may they be used for changes in 1988 by taxpayers who did not comply with the provisions of section 263A for their taxable year ending in 1987. (For example, the provisions of this paragraph may not be used for changes in 1988 by taxpayers whose method of capitalizing costs under section 263A of the Code for 1987 was unreasonable and not in conformity with section 263A and the regulations thereunder. Such taxpayers, however, may adopt these safe harbors for 1987 by filing an amended Federal income tax return for such year, as provided in this notice).

PROCEDURAL INFORMATION

This notice serves as an "administrative pronouncement" as that term is described in section 1.6661-(3)(b)(2) of the regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.

FURTHER INFORMATION

For further information regarding this notice, please contact Paulette C. Galanko of the Legislation and Regulations Division at (202) 566-3238 (not a toll-free call).