The provision which states that the Secretary of the Treasury may prescribe regulations setting forth exceptions to the general rule that a corporation (or partnership) may spread the adjustments required by the change of accounting method over a 10-year period, is, in general, intended to give the Internal Revenue Service discretion to set forth standards as to when a different period for taking the adjustments into account would be appropriate.31 Effective Date This provision will apply to taxable years beginning after December 31, 1976. Revenue effect It is estimated that this provision will result in an increase in budget. receipts of $8 million in fiscal 1977 and $18 million annually thereafter. d. Termination of Additions to Excess Deductions Accounts Under Sec. 1251 (sec. 206 of the Act and sec. 1251 of the Code) Prior law Under prior law (sec. 1251), individuals who reported their farm operations on the cash method of accounting, and who have more than $50,000 of nonfarm adjusted gross income during a year, have been required to maintain an "excess deductions account" (EDA) for a net farm loss sustained in the same year to the extent the loss exceeds $25,000. (It is immaterial what specific farm deductions produced the farm loss.) The EDA account is a cumulative account adjusted from year to year take into account net farm income or loss. For the most part, when the farm assets used in the taxpayer's business (except depreciable real property) are sold or otherwise disposed of, the portion of the gain on the sale or other disposition equal to the balance in the excess deductions account must be reported as ordinary income, rather than capital gain. Any gain recaptured in this manner is then subtracted from the balance in the EDA account as of the end of the same taxable year.32 In the case of dispositions of farm land, another provision (sec. 1252) requires recapture of deductions allowed for soil and water conservation expenditures (sec. 175) and for land clearing expenditures (sec. 182) on a gradually reducing scale depending on how long the land is held. However, if recapture is required as a result of an EDA account, this recapture is to occur in the case of a gain or disposition even though the property is subject to a lesser recapture as a result of prior soil and water expenditures or prior land clearing expenditures. Under prior law, if a corporation had a balance in an EDA account, an otherwise tax free reorganization in which farm recapture property was transferred to another corporation in exchange for its stock and the stock was then distributed would result in EDA recapture unless It is contemplated that the Internal Revenue Service might, for example, believe that a shorter period would be appropriate where the taxpayer has been in existence fewer than 10 years prior to the year of change or where the taxpayer is a partnership with a limited life which, as of the year of change, is less than 10 additional years. Corporations (other than subchapter S corporations) and trusts have been required to establish an EDA account for the full amount of their farm losses regardless of size and regardless of the amount of their nonfarm income. A subchapter S corporation has been governed by the same dollar limitations that apply to individuals, except that the corporation has been required to include in its nonfarm income the largest amount of nonfarm income of any of its shareholders. substantially all of the assets of the first corporation were transferred to the second corporation. Reasons for change Prior law allowed a farm investor who used the cash method of accounting to defer current taxes on his nonfarm income. It merely placed a potential limit on the amount of ordinary nonfarm income which might be converted to capital gain in a future year. Thus, even where an EDA account was required to be maintained, this provision reduced the conversion of ordinary income into capital gain but did not affect the time value of deferring taxes on nonfarm income or on annual farm crop income. The experience with this provision since it was enacted in 1969 also suggested that the dollar floors which must be reached before farm losses were subject to recapture are quite high, and that the application of the provision was very limited. Treasury statistics of income since 1969 show that the number of tax returns which show nonfarm income of $50,000 and higher and a net farm loss of $25,000 or more has generally been less than one percent of all returns which report both nonfarm income and farm losses. Treasury statistics also show that the provision affects no more than 8 percent of the dollar amount of all farm losses reported on returns which show both nonfarm income and farm losses. Furthermore, it appears that the provision is difficult to apply and susceptible of varying interpretations. Congress concluded that an approach which focused solely on preventing conversion of ordinary nonfarm income to capital gain, without limiting the initial deferral of current taxes on nonfarm income, did not deal effectively with the use of farm tax rules by high income taxpayers to "shelter" non farm income, particularly in some of the more flagrant abuses of the farm tax rules in publicly syndicated farm tax shelters which have been carefully structured to avoid or minimize the effects of section 1251. Since the new provisions limiting the deductions in the case of farm syndicates, providing an at risk limitation for farm operations, and requiring certain corporations to use the accrual method of accounting, will prevent the deferral of taxes on nonfarm income in many cases. Congress did not believe that it was desirable to continue a complex rule of limited applicability in the statute which recaptures income previously offset by certain farm losses. Also, Congress believed that it was inappropriate for EDA recapture to be triggered by a divisive "D" reorganization so long as the amounts in the EDA account would remain subject to recapture (under rules which are at least as stringent as if the reorganization had not occurred) when farm recapture property is disposed of by a corporation which survived the reorganization. Explanation of provision The Act limits the future applicability of the EDA provision (sec. 1251) by providing that no additions to an excess deductions account need be made for net farm losses sustained in any taxable year beginning after December 31, 1975. Farm losses incurred during any such taxable year or years will instead be governed by other limitations under the Act. If property which is "farm recapture property" (within the meaning of section 1251 (e) (1)) is disposed of during a taxable year beginning after December 31, 1975, however, the recapture rules of present law will continue to apply, but only with respect to EDA accounts required to be maintained for one or more years beginning before December 31, 1975. The Act allows divisive "D" reorganizations without triggering EDA recapture. In these reorganizations, the entire EDA account is applied to both the transferor corporation and the transferee corporation. Effective date The amendments to section 1251 will not affect any recapture of farm losses by reason of a disposition of farm recapture property during a taxable year beginning on or before December 31, 1975. In the case of dispositions of farm land, the termination of the provision described here for farm losses incurred in taxable years beginning after December 31, 1975, will mean that deductions taken under sections 175 and 182 in years beginning after December 31, 1975, will continue to be subject to recapture, but only to the extent required by section 1252. In such cases, section 1251 will cease to apply to any deductions under sections 175 and 182. The provisions relating to "D" reorganizations apply to reorganizations occurring after December 31, 1975. Revenue estimate It is estimated that these provisions will result in a decrease in tax liability of less than $5 million annually. e. Scope of Waiver of Statute of Limitations in Case of Activities Not Engaged in for Profit (sec. 214 of the Act and sec. 183(e) of the Code) Prior law The tax law distinguishes between activities engaged in "for profit" and activities which are not engaged in for profit (sec. 183). In the case of an activity engaged in for profit, a taxpayer may deduct all attributable to the activity even though they exceed the income from the activity. In the case of an activity not engaged in for profit, a taxpayer can deduct the allowable expenses attributable to the activity only to the extent that income derived from the activity exceeds amounts allowable for interest, taxes and casualty losses attributable to the activity. A taxpayer thus cannot utilize an operating loss incurred in an activity of this kind to offset his other income. Activities which raise issues of this kind include horse breeding, cattle breeding, the racing or showing of horses, and vacation homes. In determining whether an activity is engaged in for profit, the facts and circumstances must be examined to determine whether the taxpayer entered the activity and continued it with the objective of making a profit. However, the tax law contains a provision under which an activity is presumed to be engaged in for profit if the activity shows a profit in at least 2 out of 5 consecutive taxable years ending with the taxable year in question. (In the case of raising, breeding, training or showing horses, the requirement is a profit in at least 2 of 7 consecutive years.) If, at the end of a given year, the taxpayer has not conducted the activity for 5 (or 7) years, a special provision allows the taxpayer to elect to postpone a determination as to whether he can benefit by this presumption until he has conducted the activity for 5 (or 7) years (sec. 183 (e)). This election was added to the Code in 1971. The committee reports at that time expressed an intent that a taxpayer who made the election should be required to waive the statute of limitations for the 5 (or 7) year period and for a reasonable time thereafter. The aim was to prevent statute of limitations (3 years, in the usual case) from running on any year in the period. The taxpayer, it was believed, should have time to claim a refund of tax paid by him during the period, and the Internal Revenue Service should also have time to assess any deficiency owned by the taxpayer for any year in the period. In carrying out this legislative intent, the Service has issued temporary regulations which require a taxpayer who makes an election. under section 183 (e) to agree to extend the statute of limitations for each taxable year in the 5 (or 7) year period to at least 18 months after the due date of his return for the last year in the period. Such an extension must apply to all potential income tax liabilities arising during the period, including issues unrelated to deductions subject to section 183 issues. The reason for requiring such a broad waiver stems from a provision under prior law which, in certain circumstances, allows only one notice of deficiency to be sent to a taxpayer with respect to a taxable year. If a taxpayer receives a notice of deficiency and then files a petition with the Tax Court relating to that notice, the Service cannot (as a general rule) determine an additional deficiency for the same taxable year (sec. 6212 (c)). Therefore, if, within the present limitations period, the Service sends a deficiency notice to a taxpayer relating to an issue other than section 183 and the taxpayer petitions the Tax Court as to one or more of those issues, the Service cannot later assess a separate deficiency under section 183. In order to prevent such a result, the temporary regulations require the waiver to cover all tax issues during the presumption period and not just the potential section 183 issues. Reasons for change The requirement that all items on a taxpayer's returns for the early years of a 5 (or 7) year period be kept open creates several problems. The taxpayer must retain all records for those years for a substantially longer period of time than otherwise would be the case. Leaving the statute of limitations open for the entire return because of an item which may well be relatively minor is also contrary to the policy of prompt resolution of tax disputes. A taxpayer may also want a prompt resolution of other items on his return in order to limit his potential interest cost as to any deficiency arising from items not related to the section 183 issues on his return. In order to accomplish the purposes which Congress sought when it enacted the look-forward presumption of section 183(e), it is not necessary to keep the statute of limitations open for all issues on the taxpayer's return during the 5 (or 7) year period. The only issues on which the statute of limitations needs to remain open concern the deductions which will be tested as to whether they are incurred in an activity which the taxpayer engaged in for profit. Congress believes that a taxpayer should be able to take full advantage of a statutory presumption which was intended for his benefit, without unnecessarily extending the statute of limitations for items on his return which are unrelated to deductions which might be disallowed under section 183. Explanation of provision The Act revises prior law (sec. 183 (e)) to provide that if a taxpayer elects to postpone the determination of his conduct of an activity under the presumption provisions, the statutory period for the assessment of any deficiency specifically attributable to that activity during any year in the 5 (or 7) year period shall not expire until at least two years after the due date of the taxpayer's income tax return for his last taxable year in the period. If a taxpayer makes an election under section 183 (e) and postpones a determination whether he engaged in a particular activity for profit, the making of this election automatically extends the statute of limitations, but only with regard to deductions which might be disallowed under section 183. The taxpayer would not have to agree to extend the statute of limitations for any other item on his return during the 5 (or 7) year period. On the other hand, even if the taxpayer has petitioned the Tax Court with regard to an unrelated issue on his return for any year in the same period, the Service will be able to issue a second notice of deficiency relating to a section 183 issue as to any taxable year in the period. In order to assure the Service adequate time to reexamine the section 183 issue after the suspension period has ended, this new provision allows the Service two years after the end of the period in which to contest the taxpayer's deductions. The making of the election extends the statute of limitations on any year in the suspension period to at least two years after the due date of his return for the last year in the period.33 (The due date is to be determined without regard to extensions of time to file his return for the last year.) The taxpayer's limited waiver of the statute of limitations would include not only the section 183 issue itself but also deductions, etc., which depend on adjusted gross income and which might be affected if the deductions are disallowed in accord with section 183. The provision for this limited waiver is not intended to affect the scope or duration of any general waivers of the statute of limitations which taxpayers have signed (or sign) before the date of enactment of this Act (October 4, 1976).34 33 The Act does not shorten the usual 3-year statute of limitations as to any taxable year in the 5 (or 7) year period. Rather, it requires that the normal limitations period be extended as to any year in the 5 (or 7) year period as to which the normal 3-year limitation period would otherwise expire while the potential section 183 issues are held in suspense. 34 The provision is not designed to affect existing general waivers of the statute of limitations, because to do so would allow taxpayers who have previously signed such waivers to escape an examination of issues not related to section 183 even though the Internal Revenue Service had attempted to make a timely audit of them. Thus, for example if. before the date of enactment of this bill, in examining a taxpayer's income tax returns for 1970, a revenue agent had proposed adjustments to a taxpayer's allegedly unsubstantiated charitable contributions and to his horse breeding activities, and if the taxpayer made an election under section 183 (e), and signed a general waiver of the statute of limitations until October 15, 1978 (1.e., until 18 months after the due date of his 1976 return), the agent could issue the taxpayer a deficiency notice for both items at any time prior to that date. After that date, however, the statute of limitations would continue to be open for issues relating to horse breeding activities conducted in 1970 until April 15, 1979, but would be closed for issues relating to the proper substantiation of charitable contributions after October 15, 1978. |