7911 / What costs of a breeding program must be capitalized? When may a deduction be taken for costs that are expensed?

In the case of most “tax shelters,” certain corporations engaged in farming, and partnerships with a corporation as a partner, those expenses incurred in connection with producing cattle or attributable to cattle acquired for resale must be capitalized or added to the cost of inventory.¹ Generally, including these costs in inventory or capitalizing these costs prevents a current expense deduction and also has the effect of reducing income or gain from the sale of the property. Therefore, taxpayers affected by these rules would generally not be able to expense the costs of breeding or raising cattle.

Exceptions to certain of the uniform capitalization rules are available to the following entities that are engaged in farming: (1) a sole proprietorship; (2) a partnership that is not a “tax shelter” and that does not have a non-exempt corporation as a partner; (3) an S Corporation engaged in farming that is not deemed to be a “tax shelter;” and (4) any corporation engaged in farming that is not deemed to be a “tax shelter” and that meets certain gross receipts tests. A corporation meets the gross receipts test if its average annual gross receipts for the three prior tax years do not exceed $25 million (indexed to $31 million in 2025, $30 million in 2024, $29 million in 2023 and $27 million in 2022). For purposes of the gross receipts tests, all members of a controlled group of corporations are considered one corporation.² The exceptions available to these taxpayers are as follows:

(a)  Any animal produced by the taxpayer that had a preproductive life of two years or less where costs were incurred by the taxpayer before 1989.³ While “preproductive life” is not defined in the IRC, as described here, it appears to mean the period before which the animal was reasonably expected to be sold or disposed of.⁴

(b)  Any animal produced by the taxpayer without regard to the length of its preproductive life, where costs were incurred after 1988.⁵

A “tax shelter” is (1) any enterprise, other than a C corporation, if at any time interests in the enterprise have been offered for sale in an offering required to be registered with any federal or state securities agency, or (2) any farming enterprise other than a C corporation that allocates more than 35 percent of its losses during any period to investors who do not actively take part in the management of the operation, or (3) any enterprise a significant purpose of which is tax avoidance.⁶

For rules treating certain publicly traded partnerships as corporations, see Q 7728.

Other Expenses

Generally, corporations engaged in farming (other than those exempted from the capitalization rules, as described above), partnerships with a corporation as a partner, and “tax shelters” are required to use the accrual method of accounting.⁷

The accrual method of accounting precludes current deductions for amounts not yet economically incurred. Thus, in the case of farming entities required to use the accrual method, the practice of taking a deduction for expenses that are paid for but not yet needed is eliminated. This is accomplished by requiring that deductions may not be taken until (1) all events have occurred that establish that the expense has been incurred, and (2) the amount of the liability can be established with reasonable accuracy. No amount is considered to be “incurred” until “economic performance” occurs. For example, if a limited partnership that is treated as a “tax shelter” is obligated to pay for services or property, economic performance takes place as the services or property are provided. Similarly, if the limited partnership is required to pay for use of property, economic performance occurs as the limited partnership uses the property.⁸

Generally, a deduction by accrual basis taxpayers is allowed for certain “recurring items” in the tax year prior to the occurrence of economic performance if the amount and existence of the obligation have been established in the prior year, and economic performance occurs within the shorter of a reasonable period or 8½ months after the close of the taxable year.⁹ However, “tax shelters” generally may not use this exception to the economic performance rule.¹⁰

A special rule applies to the deduction of expenses for feed and similar supplies by “tax shelters,” corporations, and partnerships required to use the accrual method. A deduction for the taxable year is limited to amounts of feed or supplies actually used or consumed during the taxable year (except for amounts on hand at the end of the year due to fire, storm, other casualty, or disease or drought).¹¹

In the case of taxpayers who are permitted to use the cash method, deductions for feed and supplies are also limited if the taxpayers are not primarily engaged in farming and they have unconsumed farm supplies at the end of the tax year in excess of 50 percent of the deductible farming expenses for that year (other than the unconsumed farm supplies). The amount of unconsumed expenses in excess of 50 percent of deductible farm expenses (other than the unconsumed farm supplies) may not be taken until the taxable year the feed or supplies are used or consumed.¹²

Investors who do not materially participate in the management of a cattle breeding program may also have the deductibility of expenses limited by the effect of the “passive loss” rules (see Q 8010).

For rules treating certain publicly traded partnerships as corporations, see Q 7728.