Rev. Rul. 84-35

1984-1 C.B. 31, 1984-10 I.R.B. 7.

                       Internal Revenue Service
                                 Revenue Ruling

    BUSINESS EXPENSES;  LIVESTOCK INVESTMENT PROGRAM;  CAPITAL EXPENDITURES;
                  FARMERS;  CATTLE BREEDING SERVICE AGREEMENTS

                            Published: March 5, 1984

26 CFR 1.162-12: Trade or business expenses

(Also Section 263; 1.263(a)-1.)

  Business expenses;  livestock investment program;  capital expenditures;  farmers;  cattle breeding service agreements.  A limited partnership that expended amounts pursuant to an agreement, under which the seller offered to sell cattle to the partnership for a specified amount plus a monthly maintenance fee and the partnership could cancel the agreement at any time, is not permitted to deduct the maintenance fee for periods prior to the date the cattle were purchased.

ISSUE

  What is the proper treatment, for federal income tax purposes, of certain amounts paid to the seller on the purchase of cattle under the circumstances described below?

FACTS

  P is a limited partnership formed on January 4, 1982, to engage in integrated cattle breeding and feeding operations.  Corporation X, an affiliate of P's general partner, engages in the purchase and sale of cattle as both principal and agent.

  On January 4, 1982, P and X entered into an agreement giving P the right to purchase from X a herd of up to 2,000 cattle at a price of 100x dollars per head.  P also agreed to pay X 5x dollars a month for each animal purchased pursuant to the agreement to cover X's maintenance expenses on the herd from the date of the agreement until the cattle are delivered to P.  Under the terms of the agreement, P had no obligation to purchase any cattle and could cancel at any time in 1982 without further obligation.

  During 1982, X entered into similar agreements with other parties, maintaining sufficient cattle to satisfy all outstanding agreements.  None of the cattle that X owned were designated as being held for a specific party.

  On November 1, 1982, P elected to purchase 1,000 cattle from X. X delivered the herd to P in accordance with the agreement and received 150,000x dollars (100x + 50x dollars per animal) from P in full payment.

  On its 1982 federal income tax return, P treated 100,000x dollars of the payment to X as the capital cost of acquiring the herd.  P reported the 50,000x dollar balance of the payment as maintenance expenses deductible in the year paid.

LAW AND ANALYSIS

  Section 162 of the Internal Revenue Code allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

  Section 1.162-12(a) of the Income Tax Regulations, relating to expenses of farmers, provides that purchase of feed and other costs connected with raising livestock may be treated as expense deductions if the costs represent actual outlay.  However, amounts expended in purchasing livestock for breeding are investments of capital and shall be depreciated unless the animals are included in an inventory in accordance with 1.61-4 of the regulations.

  Section 263(a) of the Code provides generally that no deduction shall be allowed for capital expenditures.

  A taxpayer who owns livestock can treat maintenance costs as expenses which are currently deductible.  However, a taxpayer who pays the costs of maintaining animals prior to their purchase must treat such costs as part of the animals' purchase price.  Rev. Rul. 79-176, 1979-1 C.B. 123;  Rev. Rul. 78- 411, 1978-2 C.B. 112; Duggar v. Commissioner, 71 T.C. 147 (1978);  and Wiener v. Commissioner, 58 T.C. 81 (1972), aff'd per curiam, 494 F.2d 691 (9th Cir.1974).

  Under the terms of the agreement between P and X, X merely extended to P an offer to sell the cattle at a price that varied depending upon the date of sale.  P did not purchase the cattle until November 1, 1982.  Thus, the 50,000x dollar payment representing the cost of maintaining the cattle during the period before P acquired the cattle is not a deductible expense of P.  Such costs are part of the animals' purchase price.

  It should be noted that the purchase price in this class may be in excess of the animals' fair market value since the general partner of P is related to X and there is no indication that the terms of the purchase were arrived at through arm's length negotiation.  Under these circumstances the transaction will be carefully scrutinized to ensure that the payment was not for a purpose other than the acquisition of the cattle and that entire payment should be reflected in the basis of the cattle.  See

Lemmen v. Commissioner, 77 T.C. 1326 (1981).

HOLDING

  P may not deduct in 1982 the amount P paid to X for X to maintain the cattle prior to the date the cattle were sold to P.

Rev. Rul. 84-35, 1984-1 C.B. 31, 1984-10 I.R.B. 7.