Tax Law and Business Organization Strategy

Sales of Livestock Due to Drought

The drought in the Texas Panhandle and surrounding areas has staggered the livestock industry. Many livestock farmers have been forced to liquidate their herds entirely, or at an abnormal rate. The Code provides some tax relief available for farmers who have sold livestock due to the drought. The two principal provisions are Section 1033 and Section 451.

Section 1033

 

Section 1033 applies to the involuntary conversion of property. The gain on property that is sold in an involuntary conversion can be deferred if the seller purchases other property similar or related in service or use and elects to defer the gain. The gain on livestock held for draft, breeding, or dairy purposes that are sold due to drought, flood, or other weather-related conditions can qualify for this deferral. Specifically, the sale or exchange of qualifying livestock that exceeds the amount the taxpayer would have sold if the taxpayer followed his or her usual business practices, qualifies as an involuntary conversion assuming the livestock are sold or exchanged solely on account of drought, flood, or other weather-related conditions.

 

Additionally, when the taxpayer's geographic area has been designated as eligible for assistance by the federal government, the period for acquiring replacement property is extended to four years after the close of the first tax year in which any part of the gain upon conversion is realized. And, the IRS can further extend the replacement period on a regional basis if it determines that the weather-related conditions continue for more than three years.

 

If property is involuntarily sold on account of drought, flood, or other weather-related conditions, and is then replaced with similar property, “at the election of the taxpayer, the gain shall be recognized only to the extent that the amount realized upon conversion (regardless of whether such amount is received in one or more taxable years) exceeds the cost of such other property or stock.”

 

If it is not feasible for the taxpayer to reinvest the proceeds from compulsorily or involuntarily converted livestock in property similar or related in use to the livestock so converted, other property used for farming purposes qualifies as property similar or related in service or use to the livestock so converted.

 

Section 451

 

Section 451(e) allows a taxpayer (1) whose principal trade or business is farming and (2) who reports taxable income using the cash method to elect to defer a portion of income realized on the sale of certain livestock on account of drought, flood, or other weather-related conditions. This deferral is for one year and applies to the amount of income realized during the tax year from the sale or exchange of the number of head of livestock sold or exchanged solely on account of a drought that caused an area to be designated as eligible for assistance by the federal government. That designation could be made by an agency or department of the federal government, or by the President.

 

The election is available only (1) if the livestock would not have otherwise been sold except for the drought and (2) if the number sold exceeded usual business practice. The portion of the realized income that may be deferred is equal to the excess of the number of livestock sold or exchanged over the number that would have been disposed if the taxpayer had followed its usual business practices had there not been such drought.

 

As long as the drought that caused an area to be designated as eligible for federal assistance also caused the sale or exchange of livestock, deferral may be had regardless of whether the disposition of the livestock occurred before or after the area became eligible for federal assistance. In addition, the livestock do not have to be raised and the disposition does not have to take place in a drought area. The overriding criterion is that the reason for the sale or exchange of the livestock is due to drought conditions that affected the water, grazing, or other requirements of the livestock thereby necessitating their sale or exchange.

 

A separate election to have the provisions of Section 451(e) apply must be made for each broad category of animals (such as cattle, sheep, or hogs), and that election will not be based solely on the animals' breed, sex, or age. Further, the election is not available for livestock as described in Section 1231(b)(3), which pertains to cattle, horses, and other livestock held for 24 months (12 months) and used for draft, breeding, dairy, or sporting purposes. That is, the election is not available for livestock that have been subject to depreciation.

 

In determining the number of animals to which the gain deferral applies, the number is equal to the excess of the number of livestock sold or exchanged over the number that would have been sold or exchanged had the taxpayer followed its usual business practices in the absence of such drought. This determination is made after considering all the facts and circumstances. If the taxpayer has an established sale practice, any excess above that norm would qualify for the gain deferral. However, for a taxpayer who does not have an established business practice, the usual practice of similarly situated taxpayers in the same general area is applied.

 

In calculating the amount of income that may be deferred, a ratio of the income realized from the sale or exchange of all livestock in the classification during the year to the total number of head of livestock disposed of during that year should be calculated. This ratio is then multiplied by the excess number of livestock disposed of as a result of the drought to determine the income eligible for deferral.

 

Switching from one election to the other

 

As a strategy, if the livestock qualifies for either section, taxpayers should consider making the Section 1033(e) election in the year of the sale and then, during a year included in the replacement period under Section 1033(e)(2), revoking that election and making a Section 451(e) election. Section 451(e) makes it clear that this strategy is valid.

 

On the other hand, it is not clear whether an original election under Section 451 followed by revocation and replacement by Section 1033 is allowed. In two private letter rulings, the IRS indicated “that whether the sale of livestock will be treated as an involuntary conversion under section 1033(e) is a question for the IRS district office.” However, in another private letter ruling, the IRS indicated “the Taxpayer will be deemed to have made a timely election under section 1033(e) on its original return if the requirements of that section are otherwise satisfied.” A prudent approach to revoke a Section 451 election and replace it with a Section 1033 would include a request for a ruling.

 

Conclusion

 

While an income deferral is available in the case of these forced sales or exchanges, it is not always beneficial. The taxpayer should consider several factors including:

 

whether the sale would produce long term capital gain and the sale of replacement property would produce ordinary income,

 

whether he or she has any losses to offset the income from the forced sale,

 

his or her tax bracket in both the year of the forced sale and the following year,

 

any impact on the income averaging election,

 

the impact on his or her self-employment tax, and

 

how deferring the income might affect the farmer's qualification as a farmer for purposes of the special estimated tax rules available to farmers.

 

 

Trackbacks (0) Links to blogs that reference this article Trackback URL
http://taxlaw.sprouselaw.com/admin/trackback/309531
Comments (0) Read through and enter the discussion with the form at the end
Sprouse Shrader Smith PC
701 S. Taylor, Suite 500, Amarillo TX 79101

Phone: 806.468.3300