Rules for Property Produced in a Farming Business

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8729]

RIN 1545-AV37

Rules for Property Produced in a Farming Business

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations

relating to the application of section 263A of the Internal Revenue

Code to property produced in a farming business. These regulations

affect certain taxpayers engaged in the trade or business of farming.

These regulations are necessary to provide guidance with respect to

section 263A(d).

The text of the temporary regulations also serves as the text of

the proposed regulations set forth in the notice of proposed rulemaking

on this subject in the Proposed Rules section of this issue of the

Federal Register.

DATES: These regulations are effective August 22, 1997. For dates of

applicability, see Sec. 1.263A-4T(f) of these regulations.

FOR FURTHER INFORMATION CONTACT: Jan Skelton, (202) 622-4970 (not a

toll-free call).

SUPPLEMENTARY INFORMATION:

Background

Prior to the enactment of section 263A, the rules that governed the

deduction or capitalization of costs incurred with respect to property

produced in the trade or business of farming were set forth in several

different statutory and regulatory provisions. Costs regarded as

preparatory expenditures were required to be capitalized under section

263. Preparatory expenditures are expenditures incurred prior to

raising agricultural or horticultural commodities or that otherwise

enable a farmer to begin the farming process. See, e.g., Rev. Rul. 83-

28, 1983-1 C.B. 47. Preparatory expenditures include the costs of

clearing land, leveling and grading land, drilling and equipping wells,

acquiring irrigation systems, acquiring seeds or seedlings, budding

trees, and acquiring animals.

Costs regarded as developmental expenditures (sometimes referred to

as cultural practices expenditures) were generally permitted to be

deducted, or, at a taxpayer's election, could be capitalized. See,

e.g.,Wilbur v. Commissioner, 43 T.C. 322 (1964), acq., 1965-2 C.B. 7.

Developmental expenditures are those expenditures incurred by a

taxpayer so that the growing process may continue in the desired

manner. Developmental expenditures are expenditures that, if incurred

while the plant or animal was in a productive state, would be

deductible. See, Maple v. Commissioner, 27 T.C.M. 944 (1968), aff'd,

440 F.2d 1055 (9th Cir. 1971). Developmental expenditures include the

costs of irrigating, fertilizing, spraying, cultivating, pruning,

feeding, providing veterinary services, rent on land, and depreciation

allowances on irrigation systems or structures.

Former sections 278 and 447 provided special rules requiring the

capitalization of certain developmental expenditures. Former section

278(a) provided special rules for citrus and almond groves. Under

former section 278(a), all otherwise deductible costs of developing

citrus or almond groves incurred before the end of the fourth taxable

year after permanent planting were required to be capitalized. Rev.

Rul. 83-128, 1983-2 C.B. 57, clarified that the costs incurred prior to

permanent planting were also required to be capitalized.

Former sections 278(b) and 447(b) provided special rules for

farming syndicates, corporations, and partnerships with a corporate

partner. Section 447 requires certain corporations and partnerships

with a corporate partner to use an accrual method of accounting

(accrual method). Former section 447(b) required these taxpayers to

capitalize preproductive period expenses. Preproductive period expenses

were defined as any expenses attributable to crops, animals, trees, or

other property having a crop or yield and that are incurred during the

preproductive period of such property. Soil and water conservation

expenditures, as defined in section 175, and land-clearing expenditures

as defined in former section 182, are preproductive period expenses if

they are incurred in a preproductive period of an agricultural or

horticultural activity and if the taxpayer elects to deduct these

expenses rather than capitalize them. House Comm. on Ways and Means,

Tax Reform Act of 1975, H.R. Rep. No. 94-658, 94th Cong., 1st Sess. 93

(1975).

In the case of a farming syndicate engaged in planting,

cultivating, maintaining, or developing an orchard, vineyard, or grove,

former section 278(b) required the capitalization of all otherwise

deductible expenditures incurred with respect to the orchard, vineyard,

or grove, if incurred prior to the first taxable year in which there

was a crop or yield in commercial quantities.

Former section 278(c) provided a relief provision. Under this

provision, sections 278 (a) or (b) would not require the capitalization

of developmental expenditures attributable to an orchard, vineyard, or

grove that was replanted after having been lost or damaged by reason of

freezing temperatures, disease, drought, pests, or casualty.

Section 263A, enacted in the Tax Reform Act of 1986, Public Law 99-

514, 100 Stat. 2085, 1986-3 C.B. Vol. 1 (the 1986 Act), provides

uniform capitalization rules that govern the treatment of costs

incurred in the production of property or the acquisition of property

for resale. Section 263A was enacted, in part, to

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prevent the inappropriate mismatching of income and expense that

results from the current deduction of the costs of producing property.

Section 263A generally incorporates and expands upon the rules set

forth in several code and regulatory sections, including section 263,

and former sections 278 and 447.

Section 263A(b) generally provides that the uniform capitalization

rules apply to the taxpayer's production of real or tangible personal

property. Section 1.263A-2(a)(1)(i) clarifies that for purposes of

section 263A, produce includes the following: construct, build,

install, manufacture, develop, improve, create, raise, or grow.

Sections 263A (d) and (e) provide special rules for property produced

in a farming business.

Section 263A, as enacted in 1986, generally required taxpayers to

capitalize the costs of producing plants and animals. Taxpayers not

required by section 447 or 448(a)(3) to use an accrual method were

excepted from capitalizing the preproductive period costs of plants and

animals (except animals held for slaughter) that had a preproductive

period of 2 years or less. Section 263A was amended as part of the

Omnibus Budget Reconciliation Act of 1987, Pub. L. 100-203, 101 Stat.

1330, 1987-3 C.B. Vol. 1 (the 1987 Act), the Technical and

Miscellaneous Revenue Act of 1988, Pub. L. 100-647, 102 Stat. 3342,

1988-3 C.B. Vol. 1 (the 1988 Act), and the Omnibus Budget

Reconciliation Act of 1989, Pub. L. 101-239, 103 Stat. 2106 (the 1989

Act). Under the 1988 Act, the scope of the exception for these

taxpayers is expanded to include all animals irrespective of the length

of the preproductive period.

In addition, taxpayers not required by section 447 or 448(a)(3) to

use an accrual method may elect not to capitalize the costs of plants

(other than certain costs of producing citrus and almond trees) with a

preproductive period in excess of 2 years. If a taxpayer makes this

election, the taxpayer must treat such plants as section 1245 property

and upon disposition of these plants any amount allowable as a

deduction that would, but for the election, have been capitalized must

be recaptured and treated as a deduction allowed for depreciation with

respect to such property. See section 263A(e)(1). Also, if the taxpayer

makes the election, the taxpayer and related persons must apply the

alternative depreciation system provided in section 168(g)(2) to all

property used by the taxpayer or related person predominantly in a

farming business and placed in service in any taxable year in which the

election out of section 263A is in effect. See section 263A(e)(2).

On March 30, 1987, the IRS published in the Federal Register a

notice of proposed rulemaking (52 FR 10118) by cross reference to

temporary regulations published the same day (T.D. 8131, 52 FR 10052).

Amendments to the notice of proposed rulemaking and temporary

regulations were published in the Federal Register on August 7, 1987,

by a notice of proposed rulemaking (52 FR 29391) that cross referenced

to temporary regulations published the same day (T.D. 8148, 52 FR

29375). Notice 88-24, 1988-1 C.B. 491, provided that forthcoming

regulations would modify the temporary regulations and the regulations

under Sec. 1.471-6. Notice 88-86, 1988-2 C.B. 401, provided that

forthcoming regulations would clarify the definition of a related

person for purposes of the election out of section 263A. In addition,

Notice 88-86 provided that forthcoming regulations would provide that

certain taxpayers could elect to use the simplified production method

for property used in the trade or business of farming. On August 5,

1994, the temporary regulations relating to property produced in a

farming business were reissued and published in the Federal Register

(T.D. 8559, 59 FR 39958). Because substantial changes are being made

from the 1994 temporary regulations, the IRS and Treasury Department

have decided to issue, in part, new proposed and temporary, rather than

final, regulations.

Explanation of Provisions

Property Produced in the Trade or Business of Farming

The temporary regulations clarify that the special rules of section

263A(d) apply only to property produced in a farming business. The

temporary regulations provide that for purposes of section 263A, the

term farming means the cultivation of land or the raising or harvesting

of any agricultural or horticultural commodity. Examples include the

trade or business of operating a nursery or sod farm; the raising or

harvesting of trees bearing fruit, nuts, or other crops; the raising of

ornamental trees (other than evergreen trees that are more than six

years old at the time they are severed from their roots); and the

raising, shearing, feeding, caring for, training, and management of

animals. The regulations clarify that for this purpose harvesting does

not include contract harvesting of an agricultural or horticultural

commodity grown or raised by another taxpayer. Accordingly, while a

taxpayer that grows a plant may apply the special rules of section

263A(d) to the costs of growing and harvesting the plant, the special

rules of section 263A(d) do not apply to a taxpayer that merely

contract harvests agricultural or horticultural commodities grown or

raised by another taxpayer. Similarly, the temporary regulations

clarify that the special rules of section 263A(d) do not apply to a

taxpayer that merely buys and resells plants or animals grown or raised

by another. In evaluating whether a taxpayer is engaged in the

production, or merely the resale, of plants or animals, it is

anticipated that consideration will be given to factors including: The

length of time between the taxpayer's acquisition of a plant or animal

and the time the plant or animal is made available for sale to the

taxpayer's customers, and, in the case of plants, whether plants

acquired by the taxpayer are planted in the ground or kept in temporary

containers.

The temporary regulations provide that a farming business does not

include the processing of commodities or products beyond those

activities that are incident to the growing, raising, or harvesting of

such products.

Preparatory and Developmental Costs

The IRS and Treasury Department believe that, in general, section

263A does not change the rules regarding capitalization of costs during

the preparatory period. Thus, the temporary regulations clarify that,

as under prior law, taxpayers generally must capitalize preparatory

expenditures, including the cost of seeds, seedlings, and animals;

clearing, leveling and grading land; drilling and equipping wells;

irrigation systems; and budding trees. However, because section 263A

requires the capitalization of certain indirect costs as well as direct

costs, the amount of preparatory expenditures capitalized may be

greater under section 263A than under prior law.

Section 263A expands the circumstances under which costs that were

once termed developmental expenditures must be capitalized. The

temporary regulations clarify that costs that were, in years prior to

the enactment of section 263A, regarded as developmental are included

in the category of preproductive period costs. Section 263A generally

requires the capitalization of preproductive period costs including the

costs of irrigating, fertilizing, spraying, cultivating, pruning,

feeding, providing veterinary services, rent on land, and depreciation

allowances on irrigation systems or structures. Preproductive period

costs also include real estate taxes, interest,

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and soil and water conservation expenditures incurred during the

preproductive period of a plant.

Taxpayers that are required by section 447 or 448(a)(3) to use an

accrual method must capitalize all preproductive period costs of plants

(without regard to the length of the preproductive period) and animals.

Taxpayers that are not required by section 447 or 448(a)(3) to use an

accrual method qualify for an exception to this general rule. Under

this exception, taxpayers are not required to capitalize preproductive

period costs incurred with respect to animals, or with respect to

plants that have a preproductive period of 2 years or less. Thus, under

this exception, taxpayers are required to capitalize only those

preproductive period costs incurred with respect to plants that have a

preproductive period in excess of 2 years. The temporary regulations

clarify that, for purposes of determining whether a plant has a

preproductive period in excess of 2 years, in the case of a plant grown

in commercial quantities in the United States, the nationwide weighted

average preproductive period of such plant is used.

The IRS and Treasury Department are considering the publication of

guidance with respect to the length of the preproductive period of

certain plants that will have more than one crop or yield. At the

present time, the IRS and Treasury Department anticipate that such

guidance would provide that plants producing the following crops or

yields have a nationwide weighted average preproductive period in

excess of 2 years: almonds, apples, apricots, avocados, blueberries,

blackberries, cherries, chestnuts, coffee beans, currants, dates, figs,

grapefruit, grapes, guavas, kiwifruit, kumquats, lemons, limes,

macadamia nuts, mangoes, nectarines, olives, oranges, peaches, pears,

pecans, persimmons, pistachio nuts, plums, pomegranates, prunes,

raspberries, tangelos, tangerines, tangors, and walnuts. The IRS and

Treasury Department invite comments on this issue.

Capitalization Period

Preproductive period costs (e.g., irrigating, fertilizing, real

estate taxes, etc.) are capitalized during the preproductive period of

a plant or animal. A taxpayer that grows a plant that will have more

than one crop or yield is engaged in the production of two types of

property, the plant and the crop or yield of the plant (e.g., the

orange tree and the orange). The temporary regulations clarify the

capitalization period for plants that will have more than one crop or

yield, for crops or yields of plants that will have more than one crop

or yield, and for other plants.

The temporary regulations clarify that the preproductive period of

a plant generally begins when a taxpayer first incurs costs with

respect to the plant, e.g., when the plant is acquired or the seed is

planted. In the case of the crop or yield of a plant that has become

productive in marketable quantities, the preproductive period of the

crop or yield begins when the crop or yield first appears, whether in

the form of a sprout, bloom, blossom, bud, etc.

In the case of a plant that will have more than one crop or yield,

the preproductive period of the plant ends when the plant becomes

productive in marketable quantities (i.e., when the plant is placed in

service for purposes of depreciation). In the case of the crop or yield

of a plant that has become productive in marketable quantities, the

preproductive period of the crop or yield ends when the crop or yield

is disposed of. Finally, in the case of other plants, the preproductive

period ends when the plant is disposed of.

The temporary regulations provide that the preproductive period of

an animal begins at the time of acquisition, breeding, or embryo

implantation. The temporary regulations clarify that, in the case of an

animal that will be used in the trade or business of farming, the

preproductive period generally ends when the animal is placed in

service for purposes of depreciation. However, in the case of an animal

that will have more than one yield, the preproductive period ends when

the animal produces (e.g., gives birth to) its first yield. In the case

of any other animal, the preproductive period ends when the animal is

sold or otherwise disposed of. The temporary regulations additionally

clarify that, in the case of an animal that will have more than one

yield, the costs incurred after the beginning of the preproductive

period of the first yield but before the end of the preproductive

period of the animal must be allocated between the animal and the yield

on a reasonable and consistent basis. Any depreciation allowance on the

animal may be allocated entirely to the yield.

Method of Capitalizing Costs

The temporary regulations provide that the costs required to be

capitalized with respect to farming property may, if the taxpayer

chooses, be determined using any reasonable inventory valuation method,

such as the farm-price method of accounting (farm-price method) or the

unit-livestock-price method of accounting (unit-livestock-price

method). The use of these inventory valuation methods avoids the

necessity of accounting for the costs of raising plants or animals by

tracing costs to each separate plant or animal. In addition, under the

temporary regulations, these inventory methods may be used by a

taxpayer regardless of whether the farming property being produced is

otherwise treated as inventory by the taxpayer, and regardless of

whether the taxpayer is otherwise using the cash method or an accrual

method.

The temporary regulations clarify that notwithstanding a taxpayer's

use of the farm-price method with respect to farming property to which

the provisions of section 263A apply, the taxpayer is not required,

solely by such use, to use the same method of accounting with respect

to farming property to which the provisions of section 263A do not

apply.

Under the unit-livestock-price method, the taxpayer adopts a

standard unit price for each animal within a particular class. This

standard unit price is used by the taxpayer in lieu of specifically

identifying and tracing the costs of raising each animal in the

taxpayer's farming business. Taxpayers using the unit-livestock-price

method must adopt a reasonable method of classifying animals with

respect to their age and kind so that the unit prices assigned by the

taxpayer to animals in each class are reasonable. Thus, taxpayers using

the unit-livestock-price method typically classify livestock based on

their age (for example, a separate class will typically be established

for calves, yearlings, and 2-year olds).

The temporary regulations under section 263A modify the rule set

forth in Sec. 1.471-6 providing that no increase in unit cost is

required under the unit-livestock-price method with respect to the

taxable year in which certain animals are purchased, if the purchases

occur in the last 6 months of the taxable year. The temporary

regulations provide that any taxpayer required to use an accrual method

under section 448(a)(3) must include in inventory the annual standard

unit price for all animals purchased during the taxable year,

regardless of when in the taxable year the purchases are made. The

temporary regulations further amend this rule and provide that all

taxpayers using the unit-livestock-price method must modify the annual

standard price to reasonably reflect the particular period in the

taxable year in which purchases of livestock are made, if such

modification is necessary in order to

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avoid significant distortions in income that would otherwise occur

through operation of the unit-livestock-price method. The temporary

regulations do not specify the particular modification that must be

made to the annual standard price for any particular taxpayer, but

rather allow any reasonable modification made by the taxpayer to the

annual standard price to avoid significant distortions in income. For

example, assume a taxpayer purchases and raises cattle for slaughter.

Assume further that the taxpayer is required to use an accrual method

under section 447 so that section 263A applies to the taxpayer's costs

of raising the cattle. The temporary regulations provide that the

taxpayer may not expense the costs of raising cattle that are purchased

in the latter half of the taxpayer's taxable year. Instead, the

taxpayer must modify the annual standard price so as to reasonably

capitalize the costs of raising the cattle, based on the date of their

purchase.

In Notice 88-86, the IRS noted that commentators had inquired as to

the availability of the simplified production method of accounting

(simplified production method) for farmers using the unit-livestock-

price method for the costs of raising livestock. The temporary

regulations clarify that farmers using the unit-livestock-price method

are permitted to elect the simplified production method, as well as the

simplified service cost method of accounting, under section 263A. In

such a situation, section 471 costs are the costs taken into account by

the taxpayer under the unit-livestock-price method using the taxpayer's

standard unit price determined under these temporary and final

regulations. The term additional section 263A costs includes all

additional costs required to be capitalized under section 263A

including costs that are required to be capitalized under section 263A

that are not reflected in the standard unit prices (e.g., general and

administrative costs and depreciation, including depreciation on a

calf's mother).

In light of the additional costs required to be capitalized under

section 263A, taxpayers should not adopt unit prices utilized under

pre-section 263A unit-livestock-price rules without carefully analyzing

whether these unit prices reflect all of the costs required to be

capitalized under section 263A.

Election Not To Capitalize Costs

Certain taxpayers, other than those required to use an accrual

method by section 447 or 448(a)(3), may elect not to capitalize the

preproductive period costs of certain plants even though such plants

have a preproductive period in excess of 2 years and would otherwise be

subject to the capitalization requirements of section 263A. Taxpayers

making this election may continue to deduct (subject to other

limitations of the Code) the preproductive period costs that were

deductible under the rules in effect before the enactment of section

263A. The temporary regulations clarify that although a taxpayer

producing a citrus or almond grove may make this election, the election

does not apply to the preproductive period costs of a citrus or almond

grove that are incurred before the close of the fourth taxable year

beginning with the taxable year in which the trees were planted.

If a taxpayer makes this election with respect to any plant, the

taxpayer must treat the plant as section 1245 property. In addition,

the taxpayer, and any person related to the taxpayer, must use the

alternative depreciation system of section 168(g)(2) for any property

used predominantly in a farming business that is placed in service in a

taxable year for which the election is in effect.

Casualty Loss Exception

Section 263A(d) provides an exception from capitalization for

preproductive period costs incurred with respect to plants that are

replacing certain plants that were lost by reason of certain

casualties. The temporary regulations clarify that this exception for

preproductive period costs does not apply to preparatory expenditures

or the costs of capital assets. In addition, the temporary regulations

clarify that the casualty loss exception applies whether the plants are

replanted on the same parcel of land as the plants destroyed by

casualty or a parcel of land of the same acreage in the United States.

The temporary regulations additionally clarify that the exception

applies to all plants replanted on such acreage, even if the plants are

replanted in greater density than the plants destroyed by the casualty.

Final Regulations

In final regulations, cross references to Sec. 1.263A-4T are

provided in Secs. 1.61-4, 1.162-12, 1.263A-1, and 1.471-6.

Under Sec. 1.471-6(f), taxpayers using the unit livestock method

may not subsequently change the classification or unit costs they

initially adopted without obtaining the approval of the Commissioner.

As provided in Notice 88-24, the final regulations modify the rule in

Sec. 1.471-6(f) and require that taxpayers adjust the unit prices

upward from time to time, to reflect increases in costs taxpayers

experience in raising livestock. Any other changes in the

classification or unit prices used in the unit-livestock-price method

will continue to be allowed only with the consent of the Commissioner.

Effective Date and Transitional Rule

The temporary regulations provide that, in the case of property

that is not inventory in the hands of the taxpayer, the regulations are

generally effective for costs incurred on or after August 22, 1997, in

taxable years ending after such date. In the case of inventory

property, the temporary regulations are generally effective for taxable

years beginning after August 22, 1997. However, taxpayers in compliance

with Sec. 1.263A-4T in effect prior to August 22, 1997 (See 26 CFR part

1 edition revised as of April 1, 1997.), as modified by other

administrative guidance, that continue to comply with Sec. 1.263A-4T in

effect prior to August 22, 1997 (See 26 CFR part 1 edition revised as

of April 1, 1997.), as modified by other administrative guidance, will

not be required to apply these new temporary rules until the notice of

proposed rulemaking that cross-references these temporary regulations

is finalized. The amendment to Sec. 1.471-6(f) is effective for taxable

years beginning after August 22, 1997.

Effect on Other Documents

The following publications will be obsolete when the notice of

proposed rulemaking that cross-references these temporary regulations

is finalized: Notice 87-76, 1987-2 C.B. 384; Notice 88-24, 1988-1 C.B.

491; and section V of Notice 88-86, 1988-2 C.B. 401.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It has also been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations, and because the regulations do not

impose a collection of information on small entities, the Regulatory

Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to

section 7805(f) of the Internal Revenue Code, the temporary regulations

will be submitted, and the notice of proposed rulemaking that preceded

the final regulations were submitted, to the Chief Counsel for Advocacy

of the Small Business Administration for comment on their impact on

small business.

Drafting Information: The principal author of these temporary

regulations is Jan Skelton of the Office of Assistant

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Chief Counsel (Income Tax and Accounting). However, other personnel

from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR Part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *.

Sec. 1.61-4 [Amended]

Par. 2. Section 1.61-4 is amended by:

1. Adding a new sentence ``See section 263A for rules regarding

costs that are required to be capitalized.'' at the end of the

concluding text of paragraph (a).

2. Adding a new sentence ``See section 263A for rules regarding

costs that are required to be capitalized.'' after the fourth sentence

of the concluding text of paragraph (b).

Sec. 1.162-12 [Amended]

Par. 3. Section 1.162-12(a) is amended by:

1. Removing the eighth sentence, and adding the sentence ``For

rules regarding the capitalization of expenses of producing property in

the trade or business of farming, see section 263A and Sec. 1.263A-

4T.'' in its place.

2. Adding a new sentence ``For rules regarding the capitalization

of expenses of producing property in the trade or business of farming,

see section 263A and the regulations thereunder.'' after the third

sentence.

Par. 4. Section 1.263A-0T is added to read as follows:

Sec. 1.263A-0T Outline of regulations under section 263A (temporary).

This section lists the paragraphs in Sec. 1.263A-4T.

Sec. 1.263A-4T Rules for property produced in a farming business

(temporary).

(a) Introduction.

(1) In general.

(2) Exception.

(i) In general.

(ii) Tax shelter.

(iii) Presumption.

(iv) Costs required to be capitalized or inventoried under

another provision.

(v) Examples.

(3) Farming business.

(i) In general.

(A) Plant.

(B) Animal.

(ii) Incidental activities.

(A) In general.

(B) Activities that are not incidental.

(1) In general.

(2) Examples.

(b) Application of section 263A to property produced in a

farming business.

(1) In general.

(i) Plants.

(ii) Animals.

(2) Preproductive period.

(i) Plant.

(A) In general.

(B) Applicability of section 263A.

(C) Actual preproductive period.

(1) Beginning of the preproductive period.

(2) End of the preproductive period.

(i) In general.

(ii) Marketable quantities.

(D) Examples.

(ii) Animal.

(A) Beginning of the preproductive period.

(B) End of the preproductive period.

(C) Allocation of costs between animal and first yield.

(c) Inventory methods.

(1) In general.

(2) Available for property used in a trade or business.

(3) Exclusion of property to which section 263A does not apply.

(d) Election not to have section 263A apply.

(1) Introduction.

(2) Availability of the election.

(3) Time and manner of making the election.

(4) Special rules.

(i) Section 1245 treatment.

(ii) Required use of alternative depreciation system.

(iii) Related person.

(A) In general.

(B) Members of family.

(5) Examples.

(e) Exception for certain costs resulting from casualty losses.

(1) In general.

(2) Ownership.

(3) Examples.

(4) Special rule for citrus and almond groves.

(i) In general.

(ii) Example.

(f) Effective date and transition rule.

Sec. 1.263A-1 [Amended]

Par. 5. Section 1.263A-1 is amended by:

1. Removing the last sentence of paragraph (b)(3) and adding the

sentence ``See Sec. 1.263A-4T for specific rules relating to taxpayers

engaged in the trade or business of farming.'' in its place.

2. Removing the last sentence of paragraph (b)(4) and adding the

sentence ``See Sec. 1.263A-4T, however, for rules relating to taxpayers

producing certain trees to which section 263A applies.'' in its place.

Par. 6. Section 1.263A-4T is revised to read as follows:

Sec. 1.263A-4T Rules for property produced in a farming business

(temporary).

(a) Introduction--(1) In general. The regulations under this

section provide guidance with respect to the application of section

263A to property produced in a farming business as defined in paragraph

(a)(3) of this section. Except as otherwise provided by the rules of

this section, the general rules of Secs. 1.263A-1 through 1.263A-3 and

1.263A-7 through 1.263A-15 apply to property produced in a farming

business. A taxpayer that engages in the raising or growing of any

agricultural or horticultural commodity, including both plants and

animals, is engaged in the production of property. Section 263A

generally requires the capitalization of the direct costs and an

allocable portion of the indirect costs that benefit or are incurred by

reason of the production of this property. Taxpayers that do not

qualify for the exception described in paragraph (a)(2) of this section

must capitalize these costs of producing all plants and animals unless

the election described in paragraph (d) of this section is made.

(2) Exception--(i) In general. A taxpayer is not required to

capitalize the preproductive period costs of producing plants with a

preproductive period of 2 years or less or the costs of producing

animals, if the taxpayer is not--

(A) A corporation or partnership required to use an accrual method

of accounting (accrual method) under section 447 in computing its

taxable income from farming; or

(B) A tax shelter required to use an accrual method under section

448(a)(3).

(ii) Tax shelter. A farming business is considered a tax shelter,

and thus a taxpayer required to use an accrual method under section

448(a)(3), if the farming business is--

(A) A farming syndicate as defined in section 464(c); or

(B) A tax shelter, within the meaning of section

6662(d)(2)(C)(iii).

(iii) Presumption. Marketed arrangements in which persons carry on

farming activities using the services of a common managerial or

administrative service will be presumed to have the principal purpose

of tax avoidance, within the meaning of section 6662(d)(2)(C)(iii), if

such persons prepay a substantial portion of their farming expenses

with borrowed funds.

(iv) Costs required to be capitalized or inventoried under another

provision. The exception from capitalization provided in this paragraph

(a)(2) does not apply to any cost that is required to be capitalized or

inventoried under another Code or regulatory provision, such as section

263 or section 471.

[[Page 44547]]

(v) Examples. The following examples illustrate the provisions of

this paragraph (a)(2):

Example 1. Farmer A grows trees that have a preproductive period

in excess of 2 years, and that produce an annual crop. Farmer A is

not required by section 447 or 448(a)(3) to use an accrual method.

Accordingly, Farmer A qualifies for the exception described in this

paragraph (a)(2). Since the trees have a preproductive period in

excess of 2 years, Farmer A must capitalize the direct costs and an

allocable portion of the indirect costs that benefit or are incurred

by reason of the production of the trees. Since the annual crop has

a preproductive period of 2 years or less, Farmer A is not required

to capitalize the costs of the crops.

Example 2. Assume the same facts as Example 1, except that

Farmer A is required by section 447 or 448(a)(3) to use an accrual

method. Farmer A does not qualify for the exception described in

this paragraph (a)(2). Farmer A is required to capitalize the direct

costs and an allocable portion of the indirect costs that benefit or

are incurred by reason of the production of the trees and crops,

including all preproductive period costs.

(3) Farming business--(i) In general. A farming business means a

trade or business involving the cultivation of land or the raising or

harvesting of any agricultural or horticultural commodity. Examples

include the trade or business of operating a nursery or sod farm; the

raising or harvesting of trees bearing fruit, nuts, or other crops; the

raising of ornamental trees (other than evergreen trees that are more

than 6 years old at the time they are severed from their roots); and

the raising, shearing, feeding, caring for, training, and management of

animals. For purposes of this section, the term harvesting does not

include contract harvesting of an agricultural or horticultural

commodity grown or raised by another. Similarly, the trade or business

of merely buying and reselling plants or animals grown or raised by

another is not a farming business.

(A) Plant. A plant produced in a farming business includes, but is

not limited to, a fruit, nut, or other crop bearing tree, an ornamental

tree, a vine, a bush, sod, and the crop or yield of a plant that will

have more than one crop or yield. Sea plants are produced in a farming

business if they are tended and cultivated as opposed to merely

harvested.

(B) Animal. An animal produced in a farming business includes, but

is not limited to, any stock, poultry or other bird, and fish or other

sea life raised by the taxpayer. Thus, for example, the term animal may

include a cow, chicken, emu, or salmon raised by the taxpayer. Fish and

other sea life are produced in a farming business if they are raised on

a fish farm.

A fish farm is an area where fish or other sea life are grown or

raised as opposed to merely caught or harvested.

(ii) Incidental activities--(A) In general. Farming business

includes processing activities that are normally incident to the

growing, raising, or harvesting of agricultural products. For example,

a taxpayer in the trade or business of growing fruits and vegetables

may harvest, wash, inspect, and package the fruits and vegetables for

sale. Such activities are normally incident to the raising of these

crops by farmers. The taxpayer will be considered to be in the trade or

business of farming with respect to the growing of fruits and

vegetables and the processing activities incident to their harvest.

(B) Activities that are not incidental--(1) In general. Farming

business does not include the processing of commodities or products

beyond those activities that are normally incident to the growing,

raising, or harvesting of such products.

(2) Examples. The following examples illustrate the provisions of

this paragraph (a)(3)(ii):

Example 1. Individual A is in the business of growing and

harvesting wheat and other grains. Individual A also processes grain

that Individual A has harvested in order to produce breads, cereals,

and other similar food products, which Individual A then sells to

customers in the course of its business. Although Individual A is in

the farming business with respect to the growing and harvesting of

grain, Individual A is not in the farming business with respect to

the processing of such grain to produce the food products.

Example 2. Individual B is in the business of raising poultry

and other livestock. Individual B also operates a meat processing

operation in which the poultry and other livestock are slaughtered,

processed, and packaged or canned. The packaged or canned meat is

sold to Individual B's customers. Although Individual B is in the

farming business with respect to the raising of poultry and other

livestock, Individual B is not in the farming business with respect

to the slaughtering, processing, packaging, and canning of such

animals to produce the food products.

(b) Application of section 263A to property produced in a farming

business--(1) In general. Unless otherwise provided in this section,

section 263A requires the capitalization of the direct costs and an

allocable portion of the indirect costs that benefit or are incurred by

reason of the production of any property in a farming business

(including animals and plants without regard to the length of their

preproductive period).

(i) Plants. Costs typically required to be capitalized under

section 263A include the acquisition costs of the seed, seedling, or

plant, and the costs of planting, cultivating, maintaining, or

developing such plant during the preproductive period. These costs

include, but are not limited to, management, irrigation, pruning,

fertilizing (including costs that the taxpayer has elected to deduct

under section 180), soil and water conservation (including costs that

the taxpayer has elected to deduct under section 175), frost

protection, spraying, upkeep, electricity, tax depreciation and repairs

on buildings and equipment used in raising the plants, farm overhead,

taxes (except state and federal income taxes), and interest required to

be capitalized under section 263A(f).

(ii) Animals. Costs typically required to be capitalized under

section 263A include the acquisition cost of the animal, and the costs

of raising or caring for such animal during the preproductive period.

Preproductive period costs include, but are not limited to, the costs

of management, feed (such as grain, silage, concentrates, supplements,

haylage, hay, pasture and other forages), maintaining pasture or pen

areas (including costs that the taxpayer has elected to deduct under

sections 175 or 180), breeding, artificial insemination, veterinary

services and medicine, livestock hauling, bedding, fuel, electricity,

hired labor, tax depreciation and repairs on buildings and equipment

used in raising the animals (for example, barns, trucks, and trailers),

farm overhead, taxes (except state and federal income taxes), and

interest required to be capitalized under section 263A(f).

(2) Preproductive period--(i) Plant--(A) In general. The

preproductive period of property produced in a farming business means--

(1) In the case of a plant that will have more than one crop or

yield, the period before the first marketable crop or yield from such

plant;

(2) In the case of the crop or yield of a plant that will have more

than one crop or yield, the period before such crop or yield is

disposed of; or

(3) In the case of any other plant, the period before such plant is

disposed of.

(B) Applicability of section 263A. For purposes of determining

whether a plant has a preproductive period in excess of 2 years, the

preproductive period of plants grown in commercial quantities in the

United States is based on the nationwide weighted average preproductive

period for such plant. For all other plants, the taxpayer is required,

at or before the time the seed or plant is acquired or planted, to

reasonably estimate the preproductive period of the

[[Page 44548]]

plant. If the taxpayer estimates a preproductive period in excess of 2

years, the taxpayer must capitalize preproductive period costs. If the

estimate is reasonable, based on the facts in existence at the time it

is made, the determination of whether section 263A applies is not

modified at a later time even if the actual length of the preproductive

period differs from the estimate. The actual length of the

preproductive period will, however, be considered in evaluating the

reasonableness of the taxpayer's future estimates. Thus, the nationwide

weighted average preproductive period or the estimated preproductive

period are only used for purposes of determining whether the

preproductive period of a plant is greater than 2 years.

(C) Actual preproductive period. The plant's actual preproductive

period is used for purposes of determining the period during which a

taxpayer must capitalize preproductive period costs with respect to a

particular plant.

(1) Beginning of the preproductive period. The actual preproductive

period of a plant begins when the taxpayer first incurs costs that

directly benefit or are incurred by reason of the plant. Generally,

this occurs when the taxpayer plants the seed or plant. In the case of

a taxpayer that acquires plants that have already been planted, or

plants that are tended, by the taxpayer or another, prior to permanent

planting, the actual preproductive period of the plant begins upon

acquisition of the plant by the taxpayer. In the case of the crop or

yield of a plant that will have more than one crop or yield and that

has become productive in marketable quantities, the actual

preproductive period begins when the crop or yield first appears, for

example, in the form of a sprout, bloom, blossom, or bud.

(2) End of the preproductive period--(i) In general. In the case of

a plant that will have more than one crop or yield, the actual

preproductive period ends when the plant first becomes productive in

marketable quantities. In the case of any other plant (including the

crop or yield of a plant that will have more than one crop or yield),

the actual preproductive period ends when the plant, crop, or yield is

sold or otherwise disposed of.

(ii) Marketable quantities. A plant that will have more than one

crop or yield becomes productive in marketable quantities when it is

(or would be considered) placed in service for purposes of section 168

(without regard to the applicable convention).

(D) Examples. The following examples illustrate the provisions of

this paragraph (b)(2)(i):

Example 1. (i) Farmer A, a taxpayer that qualifies for the

exception in paragraph (a)(2) of this section, grows plants that

will have more than one crop or yield. The plants are grown in

commercial quantities in the United States. Farmer A acquires the

plants by purchasing them from an unrelated party, Corporation B,

and plants them immediately. The nationwide weighted average

preproductive period of the plant is 4 years. The particular plants

grown by Farmer A do not begin to produce in marketable quantities

until 4 years and 6 months after they are planted by Farmer A.

(ii) Since the plants are deemed to have a preproductive period

in excess of 2 years, Farmer A is required to capitalize the

preproductive period costs of the plants. See paragraphs (a)(2) and

(b)(2)(i)(B) of this section. In accordance with paragraph

(b)(2)(i)(C)(1) of this section, Farmer A must begin to capitalize

such costs when the plants are planted. In accordance with paragraph

(b)(2)(i)(C)(2) of this section, Farmer A must continue to

capitalize costs to the plants until the plants begin to produce in

marketable quantities. Thus, Farmer A must capitalize the

preproductive period costs of the plants for a period of 4 years and

6 months, notwithstanding the fact that the plants, in general, have

a nationwide weighted average preproductive period of 4 years.

Example 2. (i) Farmer B, a taxpayer that qualifies for the

exception in paragraph (a)(2) of this section, grows plants that

will have more than one crop or yield. The plants are grown in

commercial quantities in the United States. The nationwide weighted

average preproductive period of the plant is 2 years and 5 months.

Farmer B acquires the plants by purchasing them from an unrelated

party, Corporation B. Farmer B enters into a contract with

Corporation B under which Corporation B will retain and tend the

plants for 7 months following the sale. At the end of 7 months,

Farmer B takes possession of the plants and plants them in the

permanent orchard. The plants become productive in marketable

quantities 1 year and 11 months after they are planted by Farmer B.

(ii) Since the plants are deemed to have a preproductive period

in excess of 2 years, Farmer B is required to capitalize the

preproductive period costs of the plants. See paragraphs (a)(2) and

(b)(2)(i)(B) of this section. In accordance with paragraph

(b)(2)(i)(C)(1) of this section, Farmer B must begin to capitalize

such costs when the purchase occurs. In accordance with paragraph

(b)(2)(i)(C)(2) of this section, Farmer B must continue to

capitalize costs to the plants until the plants begin to produce in

marketable quantities. Thus, Farmer B must capitalize the

preproductive period costs of the plants for a period of 2 years and

6 months (the 7 months the plants are tended by Corporation B and

the 1 year and 11 months after the plants are planted by Farmer B),

notwithstanding the fact that the plants, in general, have a

nationwide weighted average preproductive period of 2 years and 5

months.

Example 3. (i) Assume the same facts as in Example 2, except

that Farmer B acquires the plants by purchasing them from

Corporation B when the plants are 7 months old and that the plants

are planted by Farmer B upon acquisition.

(ii) Since the plants are deemed to have a preproductive period

in excess of 2 years, Farmer B is required to capitalize the

preproductive period costs of the plants. See paragraphs (a)(2) and

(b)(2)(i)(B) of this section. In accordance with paragraph

(b)(2)(i)(C)(1) of this section, Farmer B must begin to capitalize

such costs when the plants are planted. In accordance with paragraph

(b)(2)(i)(C)(2) of this section, Farmer B must continue to

capitalize costs to the plants until the plants begin to produce in

marketable quantities. Thus, Farmer B must capitalize the

preproductive period costs of the plants for a period of 1 year and

11 months.

Example 4. (i) Farmer C, a taxpayer that qualifies for the

exception in paragraph (a)(2) of this section, grows plants that

will have more than one crop or yield. The plants are grown in

commercial quantities in the United States. Farmer C acquires the

plants from an unrelated party and plants them immediately. The

nationwide weighted average preproductive period of the plant is 2

years and 3 months. The particular plants grown by Farmer C begin to

produce in marketable quantities 1 year and 10 months after they are

planted by Farmer C.

(ii) Since the plants are deemed to have a nationwide weighted

average preproductive period in excess of 2 years, Farmer C is

required to capitalize the preproductive period costs of the plants,

notwithstanding the fact that the particular plants grown by Farmer

C become productive in less than 2 years. See paragraph (b)(2)(i)(B)

of this section. In accordance with paragraph (b)(2)(i)(C)(1) of

this section, Farmer C must begin to capitalize such costs when it

plants the plants. In accordance with paragraph (b)(2)(i)(C)(2) of

this section, Farmer C properly ceases capitalization of

preproductive period costs when the plants become productive in

marketable quantities (i.e., after 1 year and 10 months).

Example 5. (i) Farmer D, a taxpayer that qualifies for the

exception in paragraph (a)(2) of this section, grows plants that

will have more than one crop or yield. The plants are not grown in

commercial quantities in the United States. At the time the plants

are planted Farmer D reasonably estimates that the plants will have

a preproductive period of 4 years. The actual plants grown by Farmer

D do not begin to produce in marketable quantities until 4 years and

6 months after they are planted by Farmer D.

(ii) Since the plants have an estimated preproductive period in

excess of 2 years, Farmer D is required to capitalize the

preproductive period costs of the plants. See paragraph (b)(2)(i)(B)

of this section. In accordance with paragraph (b)(2)(i)(C)(1) of

this section, Farmer D must begin to capitalize such costs when it

plants the plants. In accordance with paragraph (b)(2)(i)(C)(2) of

this section, Farmer D must continue to capitalize costs until the

plants begin to produce in marketable quantities. Thus, Farmer D

must capitalize the preproductive period costs of the plants for a

period of 4 years and 6 months,

[[Page 44549]]

notwithstanding the fact that Farmer D estimated that the plants

would become productive after 4 years.

Example 6. (i) Farmer E, a taxpayer that qualifies for the

exception in paragraph (a)(2) of this section grows plants that are

not grown in commercial quantities in the United States. The plants

do not have more than 1 crop or yield. At the time the plants are

planted Farmer E reasonably estimates that the plants will have a

preproductive period of 1 year and 10 months. The actual plants

grown by Farmer E are not ready for harvesting and disposal until 2

years and 2 months after the seeds are planted by Farmer E.

(ii) Because Farmer E's estimate of the preproductive period

(which was 2 years or less) was reasonable at the time made based on

the facts, Farmer E will not be required to capitalize the

preproductive period costs of the plants notwithstanding the fact

that the actual preproductive period of the plants exceeded 2 years.

See paragraph (b)(2)(i)(B) of this section. However, Farmer E must

take the actual preproductive period of the plants into

consideration when making future estimates of the preproductive

period of such plants.

Example 7. Farmer F, a calendar year taxpayer that does not

qualify for the exception in paragraph (a)(2) of this section, grows

trees that will have more than one crop. Farmer F acquires and

plants the trees in April, 1998. On October 1, 2003, the trees are

placed in service within the meaning of section 168. Under paragraph

(b)(2)(i)(C)(2)(ii) of this section, the trees become productive in

marketable quantities on October 1, 2003. The preproductive period

costs incurred by Farmer F on or before October 1, 2003, are

capitalized to the trees. Preproductive period costs incurred after

October 1, 2003, are capitalized to a crop when incurred during the

preproductive period of the crop and expensed when incurred between

the disposal of one crop and the appearance of the next crop. See

paragraphs (b)(2)(i)(A), (b)(2)(i)(C)(1) and (b)(2)(i)(C)(2) of this

section.

(ii) Animal. An animal's actual preproductive period is used to

determine the period that the taxpayer must capitalize preproductive

period expenses with respect to a particular animal.

(A) Beginning of the preproductive period. The preproductive period

of an animal begins at the time of acquisition, breeding, or embryo

implantation.

(B) End of the preproductive period. In the case of an animal that

will be used in the trade or business of farming (e.g., a dairy cow),

the preproductive period generally ends when the animal is (or would be

considered) placed in service for purposes of section 168 (without

regard to the applicable convention). However, in the case of an animal

that will have more than one yield (e.g., a breeding cow), the

preproductive period ends when the animal produces (e.g., gives birth

to) its first yield. In the case of any other animal, the preproductive

period ends when the animal is sold or otherwise disposed of.

(C) Allocation of costs between animal and first yield. In the case

of an animal that will have more than one yield, the costs incurred

after the beginning of the preproductive period of the first yield but

before the end of the preproductive period of the animal must be

allocated between the animal and the yield on a reasonable basis. Any

depreciation allowance on the animal may be allocated entirely to the

yield. The allocation method used by a taxpayer is a method of

accounting that must be used consistently and is subject to the rules

of section 446 and the regulations thereunder.

(c) Inventory methods--(1) In general. Except as otherwise

provided, the costs required to be allocated to any plant or animal

under this section may be determined using reasonable inventory

valuation methods such as the farm-price method or the unit-livestock-

price method. See Sec. 1.471-6. Under the unit-livestock-price method,

unit prices must include all costs required to be capitalized under

section 263A. A taxpayer using the unit-livestock-price method may

elect to use the cost allocation methods in Sec. 1.263A-1(f) or 1.263A-

2(b) to allocate its direct and indirect costs to the property produced

in the business of farming. In such a situation, section 471 costs are

the costs taken into account by the taxpayer under the unit-livestock-

price method using the taxpayer's standard unit price as modified by

this paragraph (c)(1). The term additional section 263A costs includes

all additional costs required to be capitalized under section 263A. Tax

shelters, as defined in paragraph (a)(2)(ii) of this section, that use

the unit-livestock-price method for inventories must include in

inventory the annual standard unit price for all animals that are

acquired during the taxable year, regardless of whether the purchases

are made during the last 6 months of the taxable year. Taxpayers

required by section 447 or 448(a)(3) to use an accrual method that use

the unit-livestock-price method must modify the annual standard price

in order to reasonably reflect the particular period in the taxable

year in which purchases of livestock are made, if such modification is

necessary in order to avoid significant distortions in income that

would otherwise occur through operation of the unit livestock method.

(2) Available for property used in a trade or business. The farm

price method or the unit livestock method may be used by any taxpayer

to allocate costs to any plant or animal under this section, regardless

of whether the plant or animal is held or treated as inventory property

by the taxpayer. Thus, for example, a taxpayer may use the unit

livestock method to account for the costs of raising livestock that

will be used in the trade or business of farming (e.g., a breeding

animal or a dairy cow) even though the property in question is not

inventory property.

(3) Exclusion of property to which section 263A does not apply.

Notwithstanding a taxpayer's use of the farm price method with respect

to farm property to which the provisions of section 263A apply, that

taxpayer is not required, solely by such use, to use the farm price

method with respect to farm property to which the provisions of section

263A do not apply. Thus, for example, assume Farmer A raises fruit

trees that have a preproductive period in excess of 2 years and to

which the provisions of section 263A, therefore, apply. Assume also

that Farmer A raises cattle and is not required to use an accrual

method by section 447 or 448(a)(3). Because Farmer A qualifies for the

exception in paragraph (a)(2) of this section, Farmer A is not required

to capitalize the costs of raising the cattle. Although Farmer A may

use the farm price method with respect to the fruit trees, Farmer A is

not required to use the farm price method with respect to the cattle.

Instead, Farmer A's accounting for the cattle is determined under other

provisions of the Code and regulations.

(d) Election not to have section 263A apply--(1) Introduction.

This paragraph (d) permits certain taxpayers to make an election not to

have the rules of this section apply to any plant produced in a farming

business conducted by the electing taxpayer. The election is a method

of accounting under section 446, and once an election is made, it is

revocable only with the consent of the Commissioner.

(2) Availability of the election. The election described in this

paragraph (d) is available to any taxpayer that produces plants in a

farming business, except that no election may be made by a corporation,

partnership, or tax shelter required to use the accrual method under

section 447 or 448(a)(3). Moreover, the election does not apply to the

costs of planting, cultivation, maintenance, or development of a citrus

or almond grove (or any part thereof) incurred prior to the close of

the fourth taxable year beginning with the taxable year in which the

trees were planted in the permanent grove (including costs incurred

prior to the permanent planting). If a citrus or almond grove is

[[Page 44550]]

planted in more than one taxable year, the portion of the grove planted

in any one taxable year is treated as a separate grove for purposes of

determining the year of planting.

(3) Time and manner of making the election. A taxpayer makes the

election under this paragraph (d) by not capitalizing the preproductive

period costs of producing property in a farming business and by

applying the special rules in paragraph (d)(4) of this section, on its

timely filed original return (including extensions) for the first

taxable year in which the taxpayer is otherwise required to capitalize

preproductive period costs under section 263A. Thus, in order to be

treated as having made the election under this paragraph (d), it is

necessary to report both income and expenses in accordance with the

rules of this paragraph (d) (e.g., it is necessary to use the

alternative depreciation system as provided in paragraph (d)(4)(ii) of

this section). Thus, for example, a farmer who deducts preproductive

period costs that are otherwise required to be capitalized under

section 263A but fails to use the alternative depreciation system under

section 168(g)(2) for applicable property placed in service has not

made an election under this paragraph (d) and is not in compliance with

the provisions of section 263A. In the case of a partnership or S

corporation, the election must be made by the partner, shareholder, or

member.

(4) Special rules. If the election under this paragraph (d) is

made, the taxpayer is subject to the special rules in this paragraph

(d)(4).

(i) Section 1245 treatment. The plant produced by the taxpayer is

treated as section 1245 property and any gain resulting from any

disposition of the plant is recaptured (i.e., treated as ordinary

income) to the extent of the total amount of the deductions that, but

for the election, would have been required to be capitalized with

respect to the plant. In calculating the amount of gain that is

recaptured under this paragraph (d)(4)(i), a taxpayer may use the farm

price method or another simplified method permitted under these

regulations in determining the deductions that otherwise would have

been capitalized with respect to the plant.

(ii) Required use of alternative depreciation system. If the

taxpayer or a related person makes an election under this paragraph

(d), the alternative depreciation system (as defined in section

168(g)(2)) must be applied to all property used predominantly in any

farming business of the taxpayer or related person and placed in

service in any taxable year during which the election is in effect. The

requirement to use the alternative depreciation system by reason of an

election under this paragraph (d) will not prevent a taxpayer from

making an election under section 179 to deduct certain depreciable

business assets.

(iii) Related person--(A) In general. For purposes of this

paragraph (d)(4), related person means--

(1) The taxpayer and members of the taxpayer's family;

(2) Any corporation (including an S corporation) if 50 percent or

more of the stock (in value) is owned directly or indirectly (through

the application of section 318) by the taxpayer or members of the

taxpayer's family;

(3) A corporation and any other corporation that is a member of the

same controlled group (within the meaning of section 1563(a)(1)); and

(4) Any partnership if 50 percent or more (in value) of the

interests in such partnership is owned directly or indirectly by the

taxpayer or members of the taxpayer's family.

(B) Members of family. For purposes of this paragraph (d)(4)(iii),

members of the taxpayer's family, and members of family (for purposes

of applying section 318(a)(1)), means the spouse of the taxpayer (other

than a spouse who is legally separated from the individual under a

decree of divorce or separate maintenance) and any of the taxpayer's

children (including legally adopted children) who have not reached the

age of 18 as of the last day of the taxable year in question.

(5) Examples. The following examples illustrate the provisions of

this paragraph (d):

Example 1. (i) Farmer A, an individual, is engaged in the trade

or business of farming. Farmer A grows apple trees that have a

preproductive period greater than 2 years. In addition, Farmer A

grows and harvests wheat and other grains. Farmer A elects under

this paragraph (d) not to have the rules of section 263A apply to

the preproductive period costs of growing the apple trees.

(ii) In accordance with paragraph (d)(4) of this section, Farmer

A is required to use the alternative depreciation system described

in section 168(g)(2) with respect to all property used predominantly

in any farming business in which Farmer A engages (including the

growing and harvesting of wheat) if such property is placed in

service during a year for which the election is in effect. Thus, for

example, all assets and equipment (including trees and any equipment

used to grow and harvest wheat) placed in service during a year for

which the election is in effect must be depreciated as provided in

section 168(g)(2).

Example 2. Assume the same facts as in Example 1, except that

Farmer A and members of Farmer A's family (as defined in paragraph

(d)(4)(iii)(B) of this section) also own 51 percent (in value) of

the interests in Partnership P, which is engaged in the trade or

business of growing and harvesting corn. Partnership P is a related

person to Farmer A under the provisions of paragraph (d)(4)(iii) of

this section. Thus, the requirements to use the alternative

depreciation system under section 168(g)(2) also apply to any

property used predominantly in a trade or business of farming which

Partnership P places in service during a year for which an election

made by Farmer A is in effect.

(e) Exception for certain costs resulting from casualty losses--(1)

In general. Section 263A does not require the capitalization of costs

that are attributable to the replanting, cultivating, maintaining, and

developing of any plants bearing an edible crop for human consumption

(including, but not limited to, plants that constitute a grove,

orchard, or vineyard) that were lost or damaged while owned by the

taxpayer by reason of freezing temperatures, disease, drought, pests,

or other casualty (replanting costs). Such replanting costs may be

incurred with respect to property other than the property on which the

damage or loss occurred to the extent the acreage of the property with

respect to which the replanting costs are incurred is not in excess of

the acreage of the property on which the damage or loss occurred. This

paragraph (e) applies only to the replanting of plants of the same type

as those lost or damaged. This paragraph (e) applies to plants

replanted on the property on which the damage or loss occurred or

property of the same or lesser acreage in the United States

irrespective of differences in density between the lost or damaged and

replanted plants. Plants bearing crops for human consumption are those

crops normally eaten or drunk by humans. Thus, for example, costs

incurred with respect to replanting plants bearing jojoba beans do not

qualify for the exception provided in this paragraph (e) because that

crop is not normally eaten or drunk by humans.

(2) Ownership. Replanting costs described in paragraph (e)(1) of

this section generally must be incurred by the taxpayer that owned the

property at the time the plants were lost or damaged. Paragraph (e)(1)

of this section will apply, however, to costs incurred by a person

other than the taxpayer that owned the plants at the time of damage or

loss if--

(i) The taxpayer that owned the plants at the time the damage or

loss occurred owns an equity interest of more than 50 percent in such

plants at all times during the taxable year in which the

[[Page 44551]]

replanting costs are paid or incurred; and

(ii) Such other person owns any portion of the remaining equity

interest and materially participates in the replanting, cultivating,

maintaining, or developing of such plants during the taxable year in

which the replanting costs are paid or incurred. A person will be

treated as materially participating for purposes of this provision if

such person would otherwise meet the requirements with respect to

material participation within the meaning of section 2032A(e)(6).

(3) Examples. The following examples illustrate the provisions of

this paragraph (e):

Example 1. (i) Farmer T grows cherry trees that have a

preproductive period in excess of 2 years and produce an annual

crop. These cherries are normally eaten by humans. Farmer T grows

the trees on a 100 acre parcel of land (parcel 1) and the groves of

trees cover the entire acreage of parcel 1. Farmer T also owns a 150

acre parcel of land (parcel 2) that Farmer T holds for future use.

Both parcels are in the United States. In 1998, the trees and the

irrigation and drainage systems that service the trees are destroyed

in a casualty (within the meaning of paragraph (e)(1) of this

section). Farmer T installs new irrigation and drainage systems on

parcel 1, purchases young trees (seedlings), and plants the

seedlings on parcel 1.

(ii) The costs of the irrigation and drainage systems and the

seedlings must be capitalized under section 263A. In accordance with

paragraph (e)(1) of this section, the costs of planting,

cultivating, developing, and maintaining the seedlings during their

preproductive period are not required to be capitalized by section

263A.

Example 2. (i) Assume the same facts as in Example 1 except that

Farmer T decides to replant the seedlings on parcel 2 rather than on

parcel 1. Accordingly, Farmer T installs the new irrigation and

drainage systems on 100 acres of parcel 2 and plants seedlings on

those 100 acres.

(ii) The costs of the irrigation and drainage systems and the

seedlings must be capitalized under section 263A. Because the

acreage of the related portion of parcel 2 does not exceed the

acreage of the destroyed orchard on parcel 1, the costs of planting,

cultivating, developing, and maintaining the seedlings during their

preproductive period are not required to be capitalized by section

263A. See paragraph (e)(1) of this section.

Example 3. (i) Assume the same facts as in Example 1 except that

Farmer T replants the seedlings on parcel 2 rather than on parcel 1,

and Farmer T additionally decides to expand its operations by

growing 125 rather than 100 acres of trees. Accordingly, Farmer T

installs new irrigation and drainage systems on 125 acres of parcel

2 and plants seedlings on those 125 acres.

(ii) The costs of the irrigation and drainage systems and the

seedlings must be capitalized under section 263A. The costs of

planting, cultivating, developing, and maintaining 100 acres of the

trees during their preproductive period are not required to be

capitalized by section 263A. The costs of planting, cultivating,

maintaining, and developing the additional 25 acres are, however,

subject to capitalization. See paragraph (e)(1) of this section.

(4) Special rule for citrus and almond groves--(i) In general. The

exception in this paragraph (e) is available with respect to a citrus

or almond grove, notwithstanding the taxpayer's election not to have

section 263A apply (described in paragraph (d) of this section).

(ii) Example. The following example illustrates the provisions of

this paragraph (e)(4):

Example. (i) Farmer A, an individual, is engaged in the trade or

business of farming. Farmer A grows citrus trees that have a

preproductive period of 5 years. Farmer A elects, under paragraph

(d) of this section, not to have section 263A apply to the

preproductive period costs. This election, however, is unavailable

with respect to the preproductive period costs of a citrus grove

incurred within the first 4 years after the trees were planted. See

paragraph (d)(2) of this section. After the citrus grove has become

productive in marketable quantities, the citrus grove is destroyed

by a casualty within the meaning of paragraph (e)(1) of this

section.

(ii) Farmer A must capitalize the preproductive period costs

incurred before the close of the fourth taxable year beginning with

the year in which the trees were permanently planted. As a result of

the election not to have section 263A apply to preproductive period

costs, Farmer A may deduct the preproductive period costs incurred

in the fifth year. The costs of replanting, cultivating,

maintaining, and developing the trees destroyed by a casualty are

exempted from capitalization under this paragraph (e).

(f) Effective date and transition rule. In the case of property

that is not inventory in the hands of the taxpayer, this section is

generally effective for costs incurred on or after August 22, 1997, in

taxable years ending after such date. In the case of inventory

property, this section is generally effective for taxable years

beginning after August 22, 1997. However, taxpayers in compliance with

Sec. 1.263A-4T in effect prior to August 22, 1997 (See 26 CFR part 1

edition revised as of April 1, 1997.), and other administrative

guidance, that continue to comply with Sec. 1.263A-4T in effect prior

to August 22, 1997 (See 26 CFR part 1 edition revised as of April 1,

1997.), and other administrative guidance, will not be required to

apply these new temporary rules until final regulations are published

in the Federal Register.

Sec. 1.471-6 [Amended]

Par. 7. Section 1.471-6 is amended as follows:

1. Adding two sentences to the end of paragraph (c).

2. Removing the second sentence in paragraph (d) and adding two

sentences in its place.

3. Revising the last three sentences of paragraph (f).

The additions and revision read as follows:

Sec. 1.471-6 Inventories of livestock raisers and other farmers.

* * * * *

(c) * * * In addition, these inventory methods may be used to

account for the costs of property produced in a farming business that

are required to be capitalized under section 263A regardless of whether

the property being produced is otherwise treated as inventory by the

taxpayer, and regardless of whether the taxpayer is otherwise using the

cash or an accrual method of accounting. Thus, for example, the unit

livestock method may be utilized by a taxpayer in accounting under

section 263A for the costs of raising animals that will be used for

draft, breeding, or dairy purposes.

(d) * * * If this method of valuation is used, it generally must be

applied to all property produced by the taxpayer in the trade or

business of farming, except as to livestock accounted for, at the

taxpayer's election, under the unit livestock method of accounting.

However, see Sec. 1.263A-4T(c)(3) for an exception to this rule. * * *

* * * * *

(f) * * * Except as otherwise provided in this paragraph, once

established, the unit prices and classifications selected by the

taxpayer must be consistently applied in all subsequent taxable years.

For taxable years beginning after August 22, 1997, a taxpayer using the

unit livestock method must, however, annually reevaluate the unit

livestock prices and must adjust the prices upward to reflect increases

in the costs of raising livestock. The consent of the Commissioner is

not required to make such upward adjustments. No other changes in the

classification of animals or unit prices shall be made without the

consent of the Commissioner. See Sec. 1.263A-4T for rules regarding the

computation of costs for purposes of the unit livestock method.

* * * * *

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

Approved: July 28, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 97-21772 Filed 8-21-97; 8:45 am]

BILLING CODE 4830-01-U