Expense Method Depreciation: Thomann v. Commissioner

Editor's Note: The following was excerpted from the LexisNexis Matthew Bender publication Farm Income Tax Manual, by Neil E. Harl, at 1-3 Farm Income Tax Manual § 3.20, available in print at the  LexisNexis® Store.

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Non-corporate Lessors

For lessors of property, property acquired and leased under a cash rent lease would seem to be ineligible for expense method depreciation.79 Property under a share lease should be eligible if the "meaningful participation" test is met which is less demanding than "material participation,"80 and the lessor is not a "noncorporate lessor."

Requirements of the Rule

The non-corporate lessor rule can be met if the property is manufactured or produced by the lessor; or the property leased has a lease term (taking into account options to renew) of less than 50 percent of the class life of the property and for the first 12 months after the property is transferred to the lessee, the sum of the deductions with respect to the property allowable to the lessor exceeds 15 percent of the rental income (which is allowable solely by reason of I.R.C. § 162 which does not include taxes, interest and depreciation).81 Query whether this rule was intended to apply to property leased with real estate. It is not difficult to ascertain the sum of the deductions pertaining to a fence or tile line but it is considerably more difficult to determine the amount of rental income attributable to the fence or tile line.

Consequences of Failing to Meet the Requirements

In a Tax Court case, Thomann v. Commissioner,[1] decided November 1, 2010, a farm landlord suffered the rejection of  claimed deductions for expense method depreciation over a three-year period on the grounds of failure to meet the requirements for the "non-corporate lessor" rule.[2] The tax deficiencies ($81,043) and penalties ($16,209) totaled $97,252 for amounts claimed on cash-rented land for the open years.[3] Although the real estate in question was admittedly leased under a cash rent lease arrangement, which the court viewed as inconsistent with the terms of the "non-corporate lessor" rule, it appears likely that the deduction would also have failed on the grounds that cash rented assets generally fall short of being "...purchased for use  in the active conduct of a trade or business" as is required for eligibility.[4] The more significant issue is where the line is drawn between cash-rent leases and share rent leases  for purposes of claiming expense method depreciation. Certainly the Thomann case[5] has focused attention on that issue as well as meeting the requirements under the "non-corporate lessor" rule.

 

The Facts of the Case

The taxpayer in Thomann v. Commissioner[6] owned 504 acres of farmland near Columbus Junction, Iowa. As the Tax Court put it, "around 2000" the taxpayer agreed orally  to lease 124 acres of the farmland as well as various buildings, grain storage bins and equipment to a corporation engaged in a hog farrow-to-finish operation which was owned by the taxpayer, also, at a rental of $70,000 annually. Although the lease was oral, the minutes of the corporate tenant showed the rental amount but did not identify what property was involved in the rental.[7]

 

The remaining 380 acres was later leased to an unrelated party under an oral lease that was not memorialized in writing until 2006 but even then the lease terms were not included in the written farming agreement.[8]

 

The taxpayer, in 2004, claimed expense method depreciation on $52,000 for drainage tile and a fence and $10,000 for materials to remodel the farm office including furniture and fixtures. For 2005, the taxpayer claimed expense method depreciation totaling $63,488 for a grain bin. For 2006, the taxpayer claimed $8,467 for a pickup truck and $31,000 for a grain bin and dryer.  The parties stipulated that the grain bins and dryer were leased to the corporate tenant owned by the taxpayer.[9]

 

On audit, the Internal Revenue Service disallowed the expense method depreciation deductions for the farm-related property.[10]

The Tax Court Decision

 

The Tax Court disallowed the deduction for remodeling the farm office on grounds of  lack of substantiation as to which materials were expensed on the tax return.[11]

 

The Tax Court noted that the lessor (the taxpayer) was a non-corporate lessor[12] and observed that leased property can be expensed by meeting a two-prong test - (1) the term of the lease, taking into account options to renew, must be less  than 50 percent of the class life of the leased property,[13] and the sum of the  trade or business deductions[14] for the leased property claimed during the initial 12-month period  following the transfer of the property to the lessee must exceed 15 percent of the rental income produced by the property.[15] The Tax Court did not mention the other test - where the property subject to the lease  has been manufactured or produced by the taxpayer, apparently believing that test was not met in this case.

 

The Tax Court found both leases to be  oral, cash-rent leases of indefinite duration and the taxpayer could not meet the first prong of the test - that the term of the lease must be less than 50 percent of the class life of the property.[16] Had it been a one-year cash rent lease, the question is whether the property would have been eligible for the claimed depreciation. The Tax Court also could find no evidence that the pickup truck, the grain bins or grain dryer were leased to the tenant of that particular tract of land. Hence, the expense method depreciation claimed was not deductible for that reason as well.

Eligibility of Cash-rented Assets for § 179 Depreciation Generally

The Tax Court did not mention the fact that, ordinarily, cash-rented assets are not eligible for an expense method depreciation deduction because of not being "...purchased for use in the active conduct of a trade or business."[17] The regulations state that the determination of whether a trade or business is actively conducted by the taxpayer is based on all of the facts and circumstances.[18] In general, the regulations state that it requires that the taxpayer "meaningfully participates" in the management or operations of the trade or business.[19] Thus, a one-year cash rent lease of the property would likely not have been eligible for the deduction, even though it might have passed muster with the non-corporate lessor rule.

 

With a trade or business generally believed to require that the taxpayer - (1) bears the risks of production; (2) bears the risk of price change; and (3) contributes some management or labor or both to the operation, it is generally believed that a share rent lease, either crop share or livestock share, should meet the test for claiming expense method depreciation inasmuch as a share rent lease automatically meets the first two tests. The question then is the amount and significance of the management or labor input.

 

However, in the context of the "non-corporate lessor" rule, it is not clear whether that rule targets only cash rent leases, non-material participation share rent leases or even material participation share rent leases. It is doubted, however, that material participation share rent leases, at least, would fall within the "non-corporate lessor" rule. The line is not clear.

 

The Tax Court found within the "non-corporate lessor" rule sufficient grounds for disallowing the expense method depreciation deduction. It appears that the deduction could also  have been disallowed under the "active conduct of a trade or business" requirement. There is no reason to believe that a taxpayer meeting the requirements of the "non-corporate lessor" rule is necessarily assured of deductibility.

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79I.R.C. § 179(d)(1).

80I.R.C. § 179(d)(1).

81I.R.C. § 179(d)(5)(B).

[1] T.C. Memo. 2010-241.

[2] I.R.C. § 179(d)(5). See generally 4 Harl, Agricultural Law § 29.02[8][h][viii](C) (4) (2010); Harl, Agricultural Law Manual § 4.03[4][j] (2010).

[3] Thomann v. Comm'r, T.C. Memo. 2010-241.

[4] I.R.C. § 179(d)(1)(C).

[5] Thomann v. Comm'r, T.C. Memo. 2010-241.

[6] T.C. Memo. 2010-241.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

[11] Id.

[12] I.R.C. § 179(d)(5).

[13] I.R.C. § 179(d)(5)(B).

[14] I.R.C. § 162.

[15] Thomann v. Comm'r, T.C. Memo. 2010-241. See I.R.C. § 179(d)(5)(B).

[16] I.R.C. § 179(d)(5)(B).

[17] I.R.C. § 179(d)(1)(C).

[18] Treas. Reg. § 1.179-2(c)(6)(ii).

[19] Id.