The issue of deducting residual fertilizer has surfaced as a tax issue in the upper Midwest. The question on this issue is whether a farmer purchasing land can amortize residual fertilizer left over from the individual he or she purchased the land from.
Since 2004, net farm income has steadily increased. In fact, University analysis data shows record profitability for the past several years. This increased profitability has resulted in higher land rents and of course, higher land prices. The motivation behind the idea of deducting residual fertilizer is to garner additional farm expense rather than allocating all of the purchase cost to the basis of the farm.
First and foremost, there is NOT an established IRS Revenue Procedure that states deducting residual fertilizer is okay. By the same token, there is not an IRS Revenue Procedure that says you can't. This argument is based on examination of current accepted business practices in conjunction with an aging technical advice memorandum.
It is a generally accepted practice that upon the purchase of additional land, a portion of the purchase price may be allocated to buildings, fences, and tile (cost segregation). Proponents of this procedure advocate that upon purchase the farmer should be able to allocate a portion of the purchase price to a documented amount of excess soil fertility. Many of these proponents have also advocated that this soil fertility may be identified as a flat percentage of the purchase cost. This practice has resulted in large unsubstantiated deductions that have gained the attention of both Internal Revenue Service and the Minnesota Department of Revenue, triggering numerous audits.
Currently, Minnesota Department of Revenue is examining a very high percentage of returns that show this type of transaction.
While no IRS Revenue Procedure exists for this issue, taxpayers and tax professionals alike can be referred to a Technical Advice Memorandum from 1992 (TAM 9211007). A TAM does not carry the same weight as a Revenue Procedure or IRS Code, but in this case it does provide the greatest amount of guidance available.
The guidelines of the TAM state:1
- Taxpayer must be the owner of the fertilizer supply,
- Taxpayer must establish the extent of the fertilizer supply,
- Taxpayer must establish cost basis and
- Taxpayer must show depletion and rate of decline
One of the keys to making this situation work is that the purchaser of the land must be able to establish existing fertility levels.
With regard to the extensive amount of audit activity from Minnesota Department of Revenue, the TAM guideline that taxpayers fail most often is where the taxpayer must show depletion and rate of decline. Another common argument from the State is, "If the parcel of ground has excess fertility and the farmer took a fertility deduction, why did the operator apply additional fertilizer?"
Taking a flat percentage of the initial purchase cost will not be accepted by Internal Revenue Service or Minnesota Department of Revenue. The purchasing individual must provide scientific evidence demonstrating the existence of residual soil fertility.
An additional issue that is being looked at by examining authorities is the consistency and character of the income and expense on both sides of the transaction. The seller is motivated to have all of the income from the sale treated as long-term capital gain. The buyer on the other hand desires ordinary expense that may be deducted via depreciation or amortization. Examining authorities are looking for consistency on both ends of the transaction. If there is residual soil fertility present in the property that is sold, then the seller should report that portion of the sale as ordinary income rather than capital gains. In order for this to happen in the real world any residual soil fertility should be identified at the time the transaction takes place and detailed in the sales agreement.
The authors wish to convey very strongly that current guidance from IRS does not exist. Minnesota Department of Revenue is auditing returns on this issue. In the long run, this procedure may work. The initial recommendations are to adhere to the 1992 TAM, recognize that the character of income and expense on both ends of the transaction should be consistent, and an agronomist or soil scientist must be hired in order to certify fertility levels. Ultimately this issue is going to be clarified either through a court case or an Internal Revenue Service Revenue ruling.
Note: This information piece is offered as educational information only and is not intended to be tax, legal or financial advice. For questions specific to your farm business or individual situation, consult with your tax preparer.
- 2011 National Income Tax Workbook. Land Grant University Tax Education Foundation.
1 2011 National Income Tax Workbook. Land Grant University Tax Education Foundation.