Rev. Rul. 86-24

Caution: Modified by 87-105

EXPENSES OF FARMERS; AMOUNTS PAID FOR COWS AND EMBRYO TRANSPLANTS

Published: February 24, 1986

Section 162.-Trade or Business Expenses, 26 CFR 1.162-12: Expenses of farmers.

(Also Sections 61, 263, 1012, 1231: 1.61-4, 1.263(a)-1, 1.1012-1, 1.1231-2.)

  Expenses of farmers; amounts paid for cows and embryo transplants. A purchaser of cows that are pregnant with transplanted embryos, who subsequently sells the cows and the calves separately, must allocate the original purchase price between the cows and the calves. The portion of the original purchase price that equals the fair market value of the cows is allocated to the cows; the remaining amount is allocated to the calves. Neither the costs attributable to the cows, nor the costs attributable to the embryos, are deductible currently as expenses. Gain or loss from the sale of the cows or calves is ordinary income or ordinary loss.

ISSUE

  What is the proper federal income tax treatment of the cost of (1) non- purebred cows carrying embryos transplanted from purebred cows and of (2) purebred calves under the circumstances described below?

FACTS

  After hormone treatments, purebred cows owned by X corporation are artificially inseminated with semen from a purebred bull. The embryos are surgically removed and implanted in the non-purebred cows. Following a positive pregnancy test, X offers the implanted cows for sale to the public. The cows are usually resold after giving birth to purebred calves. The purchase price of each cow pregnant with an embryo transplant is 25x dollars, which is equal to its fair market value. The fair market value of a cow similar to the implanted cow which was not pregnant is 8x dollars. The sales price of an implanted cow after it has given birth to a purebred calf is 8x dollars.

  A, an individual that uses the cash receipts and disbursements method of accounting and files income tax returns on a calendar year basis, purchased from X 10 cows pregnant with transplanted purebred embryos for 250x dollars in July 1984. A allocated the entire purchase price to the cows and none of the purchase price to the purebred embryos.

  In 1984, 10 purebred calves were born to the implanted cows and A then sold the cows for 80x dollars. Since A had allocated the entire purchase price to the cows, A intends to claim an ordinary loss of 170x dollars with respect to the sale of the cows on the 1984 federal income tax return. A intends to hold the purebred calves for sale.

LAWS AND ANALYSIS

  Section 162 of the Internal Revenue Code provides that there shall be allowed as a deduction all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.

  Section 1.162-12(a) of the Income Tax Regulations provides that the purchase of feed and other costs connected with raising livestock may be treated as expense deductions but that amounts expended in purchasing work, breeding, dairy, or sporting animals are regarded as investments of capital and shall be depreciated unless the animals are included in an inventory in accordance with section 1.61-4.

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

  In Gamble v. Commissioner, 68 T.C. 800 (1977), acq., page 5, of this Bulletin, a taxpayer purchased for $60,000 a pregnant broodmare for use in the taxpayer's business of racing thoroughbred horses. When the taxpayer purchased the pregnant broodmare, the taxpayer received a broodmare and also an unborn foal. The court concluded that the portion of the $60,000 purchase price that was properly allocable to the unborn foal became the taxpayer's cost basis in the foal under section 1012 of the Code.

  Section 1.61-4(a) of the regulation provides that, for farmers using the cash receipts and disbursements method of accounting, the profit from the sale of livestock or other items which were purchased is generally ascertained by deducting the cost from the sale price in the year in which the sale occurs. However, in the case of the sale of purchased animals held for draft, breeding or dairy purposes, the profits shall be the amount of any excess of the sale price over the amount representing the difference between the cost and the depreciation allowed or allowable.

  Section 1221 of the Code defines the term 'capital assets' as property held by the taxpayer (whether or not connected with the taxpayer's trade or business) but does not include, among other things, property used in a trade or business that is subject to an allowance for depreciation and property held by the taxpayer of a kind which would properly be included in the inventory of a taxpayer or property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

  Section 1222(3) of the Code provides that the term 'long-term capital gain' means gain from the sale or exchange of a capital asset held for more than 6 months if and to the extent such gain is taken into account in computing gross income.

  Section 1231(a) of the Code provides that if, during the tax year, the recognized gains on sales or exchanges of property used in the trade or business, plus the recognized gains from the compulsory or involuntary conversion of property used in the trade or business and capital assets held for more than 6 months into other property or money, exceed the recognized losses from such sales, exchanges, and conversions, such gains and losses from sales or exchanges of capital assets held for more than 6 months. If such gains do not exceed such losses, such gains and losses shall not be considered as gains and losses from sales or exchanges of capital assets.

  Section 1231(b)(3)(A) of the Code provides that the term 'property used in the trade or business' includes cattle, regardless of age, held by the taxpayer for draft, breeding, dairy, or sporting purposes, and held by the taxpayer for

24 months or more from the date of acquisition.

  In the present situation, A purchased cows carrying transplanted purebred embryos. The 25x dollar purchase price must be allocated to the cow and the embryo on the basis of the fair market value of each. The fair market value of the cow is 8x dollars and the fair market value of the cow plus embryo is 25x dollars. Accordingly, the portion of each 25x purchase price that is equal to the fair market value of the cows. 8x dollars, is properly treated as the purchase price of the cow. A's income from the sale of the cows will be determined in accordance with section 1.61-4(a) of the regulations. In this case, because the cows were used in a trade or business and were subject to depreciation, they are not capital assets under section 1221. Since the cows were purchased by A for breeding purposes and sold within 24 months, the cows do not qualify as property used in the taxpayer's trade or business within the meaning of section 1231(b)(3)(A) of the Code. Thus, any gain or loss on the sale of cows will be ordinary income or ordinary loss. Since only 80x dollars of the purchase price is properly allocable to the cows and A sold the cows for

80x dollars, A has no gain or loss on the sale of the cows.

  A also purchased purebred embryos that will become purebred calves. The balance of the 25x dollars that is not allocable to the cost of the cow is properly allocable to the cost of the embryo. The amount allocable to the embryo is an amount expended in purchasing livestock and must be capitalized under section 1.162-12(a) of the regulations. In this case, the calves were primarily held for sale to customers in the ordinary course of business. Thus, the calves are not capital assets under section 1221 of the Code. Thus, any gain or loss on the sale of the calves will be ordinary income or ordinary loss.

HOLDING

  The portion of the 250x dollars paid to X for the pregnant non- purebred cows, the fair market value of the cows of 80x dollars, is treated as the purchase price of the cows. A will not recognize any gain or loss on the sale of cows because A's 80x dollar basis in the cows equals the 80x dollars received on the sale.

  The balance of the 250x dollar purchase price, 170x dollars, is attributable to the cost of purchasing the purebred calves. Since the calves are not capital assets under section 1221 of the Code and are not property used in the taxpayer's trade or business within the meaning of section 1231(b), any gain or loss on the sale of the calves will be ordinary income or ordinary loss.

Rev. Rul. 86-24, 1986-1 C.B. 80, 1986-8 I.R.B. 7.