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35 percent of the losses during any year are allocable to limited partners or limited entrepreneurs, the enterprise will be treated as a farming syndicate.

In general, a limited entrepreneur means a person who has an interest, other than a limited partnership interest, in an enterprise and who does not actively participate in the management of the enterprise. The determination of whether a person actively participates in the operation or management of a farm depends upon the facts and circumstances. Factors which tend to indicate active participation include participating in the decisions involving the operation or management of the farm, actually working on the farm, living on the farm. or hiring and discharging employees (as compared to only the farm manager). Factors which tend to indicate a lack of active participation include lack of control of the management and operation of the farm, having authority only to discharge the farm manager, having a farm manager who is an independent contractor rather than an employee, and having limited liability for farm losses.18

With respect to farming activities other than those conducted by enterprises in which securities have been registered or were required to be registered, the provision specifies five cases where an individual's activity with respect to a farm will result in his not being treated as a limited partner or limited entrepreneur. These cases cover situations where an individual

(1) has an interest in a trade or business of farming attributable to his active participation for a period of not less than 5 years in the management of the trade or business of farming 14:

(2) lives on the farm on which the trade or business of farming is being carried on (but only with respect to farming activities on such farm);

(3) actively participates in the management of a trade or business of farming which involves the raising of livestock (or is treated as being engaged in active management pursuant to one of the first two exceptions set forth above), and the trade or business of the partnership or any other enterprise involves the further processing of the livestock raised in the trade or business with respect to which he is (actually or constructively) an active participant;

(4) actively participates, as his principal business activity, in the management of a trade or business of farming, regardless of whether he actively participates in the management of the activity in question; or

(5) is a member of the family (within the meaning of section 267 (c) (4)) of a grandparent of an individual who would be ex

13 In determining whether a person has limited liability for farm losses, all the facts and circumstances are to be taken into account. Generally, for purposes of this definition, a person will be considered to have limited liability for farm losses if he is protected against loss to any significant degree by nonrecourse financing, stop-loss orders, guarantees, fixed price repurchase (or purchase) agreements, insurance, or other similar arrangements. A person with limited liability for farm losses might include, in appropriate circumstances, (1) a general partner who has obtained a guaranty or other protection against loss from another general partner or an agent, and (2) a principal who has given authority, in fact, to another party to conduct his operations (such as an investor who agrees to allow a feedlot to manage feeder cattle which he has purchased) and who utilizes nonrecourse financing, stop-loss orders insurance, etc., to limit his risk.

14 This exception (and the fifth exception to the extent it applies this exception to family members of a person qualifying under this exception) will continue to apply where one farm is substituted for or added to another farm.

cepted under any of the first four cases listed above and his interest is attributable to the active participation of such individual. The first exception listed above (and its application to family members by the fifth exception) is designed to insure that the term "farming syndicate" does not include an enterprise in which a limited partnership interest (or other passive interest) is held by a person who has actively participated in the management of the enterprise for not less than five years merely by reason of his holding such a limited partnership interest (or other passive interest). Also, a member of the family of such a person, such as one of his heirs, would not be treated as a limited partner or limited entrepreneur for purposes of making the farming enterprise a farming syndicate. Thus, for example, if A, an individual who has owned and operated a farm for more than five years, wishes to retire and forms the AB limited partnership with B, an unrelated individual, and more than 35 percent of the losses are allocated to A, the limited partner, the AB partnership will not be treated as a farming syndicate because A's interest is not treated as a limited partnership interest for purposes of determining whether losses are allocated to limited partners. Similarly, if A later dies and the partnership is continued by B and C, A's son, the BC partnership will not be treated as a farming syndicate.

Definition of farming. For purposes of these farming syndicate rules, the term "farming" is defined to mean cultivation of land or the raising or harvesting of any agricultural or horticultural commodity, including the raising, shearing, feeding, caring for, training, and management of animals. Thus, for example, a syndicate engaged in the raising of livestock, fish, poultry, bees, dogs, flowers, or vegetables is engaged in farming and, thus, is a farming syndicate.

For purposes of the farming syndicate rules, activities involving the growing or raising of trees (other than fruit or nut trees) are not considering farming. Thus, this provision does not apply to forestry or the growing of timber.

Deduction of prepaid items.-The Act adds a new section (sec. 464 (a)) to the Code to provide in general, that, in the case of farming syndicates, deductions for amounts paid for feed, seed, fertilizer, or other similar farm supplies are allowed only in the taxable year in which the feed, seed, fertilizer or other supplies are used or consumed. This provision prevents a farm syndicate from obtaining current deductions for prepaid feed, seed, fertilizer, etc., except in situations where the feed, seed, fertilizer, or other supplies are on hand at the close of the taxable year solely because the consumption of such items during the taxable year was prevented on account of fire, storm, flood, or other casualty, or on account of disease or drought.

Costs of poultry.-Under prior law, taxpayers engaged in farming have not been allowed to deduct the cost of purchased livestock; rather, they must inventory the livestock held for sale and deduct the cost only upon disposition, and they must capitalize the cost of purchased livestock used in the trade or business (such as cattle held for breeding purposes) and depreciate them over their useful lives. However, this has not been the case with respect to poultry. A ruling by the Internal Revenue Service (Rev. Rul. 60-191, 1960-1 C. B. 78) has allowed cash basis taxpayers to deduct when paid the costs of both poultry held for

sale and poultry used in the trade or business. These deductions were allowable, in general, because the poultry purchased for resale has a relatively small cost, and the poultry purchased for use in the trade or business, such as laying hens, has a useful life of less than one year. Some syndicates, however, have taken advantage of these rules and, coupled with the prior rules relating to prepaid feed, have utilized the deductions for poultry to create tax shelters.

The Act adds a new Code provision (sec. 464(b)) which does not allow a farming syndicate to deduct when paid costs of acquiring poultry. Rather, it requires that the cost of poultry acquired for resale not be deducted until the poultry is sold or otherwise disposed of. Also, in the case of poultry acquired for use in the trade or business (such as laying hens) or acquired both for use in trade or business and for later resale, the costs must be capitalized and (taking into account salvage value) deducted ratably on a monthly basis over the lesser of twelve months or their useful life in the trade or business.15

Capitalization of development costs of groves, orchards, and vineyards. The Act amends section 278 to provide that, in the case of a farming syndicate, any amount otherwise allowable as a deduction which is attributable to the planting, cultivation, maintenance, or development of a grove, orchard, or vineyard, and which is incurred prior to the taxable year in which the grove, orchard, or vineyard begins to produce crops in commercial quantities is required to be capitalized. Such expenditures can thereafter be recovered by depreciation of the grove, orchard, or vineyard. A limited exception to this capitalization rule is provided for amounts allowable as deductions (without regard to section 278) which are attributable to a grove, orchard, or vineyard, which is replanted after having been lost or damaged while in the hands of the taxpayer by reason of freezing temperatures, disease, drought, pests, or casualty.

Where these new rules apply to a situation in which section 278 (a) (relating to capitalization of certain expenses of citrus and almond groves) requires capitalization but for a different period (4 years instead of the preproductive period), the rules of capitalization of section 278(a) apply prior to the capalization rules with respect to farming syndicates. Also, if an amount is incurred as a cost of fertilizer, or other prepaid supplies, which is generally subject to the rules of new section 464 (a), such amount is nonetheless subject to the farming syndicate capitalization rules of section 278 (b). Thus, in such a case, no deduction would be allowed upon consumption of the fertilizer, but rather such amount would have to be charged to capital account.

Effective dates

The provisions of the Act relating to prepaid feed and other farm supplies and poultry expenses apply generally to amounts paid or incurred in taxable years beginning after December 31, 1975. In the case of farming syndicates in existence on December 31, 1975 (but only if there is no change in membership in the farming syndicate

15 Since the only basis for deducting the cost of the laying hens currently was that they have an expected useful life of less than one year, the requirement that deductions be taken over the lesser of 1 year or the useful life should not result in the acceleration of such deductions.

throughout its taxable year beginning in 1976), these provisions apply to amounts paid or incurred in taxable years beginning after December 31, 1976.16 The provisions relating to orchards, groves and vineyards do not apply where the trees or vines were planted or purchased for planting prior to December 31, 1975, or where there was a binding contract to purchase the trees or vines in effect on December 31, 1975. Revenue effect

This provision will increase budget receipts by $86 million in fiscal year 1977, $32 million in fiscal year 1978, and $34 million in fiscal year 1981.

b. Limitation of Loss With Respect to Farms to the Amount for Which the Taxpayer Is at Risk (sec. 204 of the Act and sec. 465 of the Code)

Prior law

Generally, the amount of depreciation or other deductions which a taxpayer has been permitted to take in connection with a property has been limited to the amount of his basis in the property. Likewise, in the case of a partnership, the amount of loss a partner may deduct is limited to the amount of his adjusted basis in his interest in the partnership. However, basis in a property has included nonrecourse indebtedness (i.e. a loan on which there is no personal liability) attributable to that property. Where a partnership incurs a debt obligation, and none of the partners has personal liability on the loan, all of the partners have been treated for tax purposes as though they shared the liability in proportion to their profits interest in the partnership (i.e. each partner's share in the nonrecourse indebtedness is added to his basis in the partnership). (See regulations § 1.752-1(e)).

Also, there has been generally no limitation on deductions which take into account a taxpayer's protection against ultimate loss by reason of a stop-loss order, guarantee, guaranteed repurchase agreement, insurance or otherwise.

Reasons for change

Taxpayers have combined the special farm tax rules (discussed under the farm syndicate section above) with nonrecourse indebtedness, and stop-loss orders, etc., to deduct losses in a taxable year which are substantially in excess of the maximum amounts they could ultimately lose with respect to their investments in farming. Although some of these situations may be limited by the restrictions on deductions imposed on syndicates (as described above), some farming shelters may not involve syndicates. Also, the limitations on syndicates do not affect all types of farming operations. For instance, winter vegetables, rose bushes and other nursery plants are not restricted by the restrictions on farming syndicates, except to the extent that such syndicates utilize prepaid seed, fertilizer, and other farm supplies. (The utilization of such prepaid items is not necessary for the creation of substantial tax shelter in these types of operations.)

16 A change in membership which disqualifies a farming syndicate from this transitional rule does not include substitutions occurring by operation of law, gifts, or withdrawals by existing members.

Explanation of provisions

To prevent a situation where a taxpayer may deduct a loss in excess of his economic investment in farming operations, the Act provides that the amount of any loss (otherwise allowable for the year) which may be deducted in connection with a trade or business of farming, cannot exceed the aggregate amount with respect to which the taxpayer is at risk in each such activity at the close of the taxable year. (For more detail as to the application and scope of the at risk rule, see section 2, above.)

In applying the at risk provision to farming operations," Congress intends that the existence of a governmental target price program (such as provided by the Agriculture and Consumer Protection Act of 1973) or other governmental price support program with respect to a product grown by a taxpayer does not, in the absence of agreements limiting the taxpayer's costs, reduce the amount which such taxpayer is at risk.

In the case of farming activities carried on by an individual, the "at risk" provision applies separately to each farming activity. Whether a taxpayer is engaged in one or more farming activities depends on all the facts and circumstances of the case. Generally, some of the significant facts and circumstances in making a determination are the degree of organizational and economic interrelationship of various activities in which the taxpayer is engaged, the business purpose which is (or might be) served by carrying on the various activities separately or together, and the similarity of the various activities. Thus, for instance, if a rancher engaged in cattle raising on his own ranch also purchases cattle which he has placed in a commercial feedlot, he will generally be treated as being in two separate farming activities. However, if such a rancher were, as a consistent business practice, to take cattle raised on his own ranch and place them in a commercial feedlot, he might well be treated as engaged in only one farming activity.

All farming activities engaged in by a partnership or subchapter S corporation will be treated as one activity for purposes of applying this provision.18

Effective date

In the case of farm operations, the at risk limitation applies to losses attributable to amounts paid or incurred in taxable years beginning after December 31, 1975.

Revenue estimate

It is estimated that this provision will result in an increase in budget receipts of less than $5 million annually.

c. Method of Accounting for Corporations Engaged in Farming (sec. 207 (c) of the Act and new sec. 447 of the Code)

Prior law

Under prior law, a taxpayer engaged in farming activities was allowed to report the results of such activities for tax purposes on the

17 For purposes of the at risk provision, the term "farming" has the same meaning as it does in the farming syndicate provisions discussed above.

18 This aggregation approach is adopted because of the difficulties of allocating a partner's at risk amount between different activities.

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