In Barnhart Ranch Co. v. Commissioner, No. 16-60834 (5th Cir. 2017), the court considered who was entitled to deduct expenses for cattle that were descended from cattle the taxpayers inherited and other cattle that were subsequently purchased. The case shows how important it is to implement an accounting system to capture income and expenses in the correct legal entity, particularly when C corporations are involved.
The Facts & Procedural History
The case involved two brothers. The brothers inherited a cattle operation from their father. They also formed a C corporation to manage the cattle operation. It was not clear whether they transferred title to all or some of the cattle to the C corporation, but the C corporation acquired title to newly purchased cattle. The brothers held the C corporation out as the owner of the cattle.
The brothers deducted the costs for the cattle operations on their personal income tax returns. On audit, the IRS argued that the expenses for the cattle operation were incurred by the C corporation and the corresponding deduction belonged to the C corporation. The IRS disallowed the deductions on the brothers personal returns and the dispute ended up being litigated.
Agency via Joint Interest Accounting System
At the trial court level, the brothers argued that the C corporation was merely an agent.
The C corporation employed joint interest accounting system that is common in the Texas oil and gas business. This accounting system involves having one entity, typically the operator, receive the revenues and incur the expenses for the owners, including the operator and the nonoperators, to exploit the oil and gas lease or rights.
For Federal income tax purposes, the revenue and expenses that are allocated to the operator and nonoperators belong to the parties that receive the allocations. For this arrangement to work, there are six factors that have to show that there is an agency arrangement:
- The corporation operates in the name and for the account of the principal,
- The corporation binds the principal by its actions,
- The corporation transmits money received to the principal,
- The receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal,
- The corporation’s relations with its principal is not be dependent upon the fact that it is owned by the principal, if such is the case, and
- The corporation’s business purpose is the carrying on of the normal duties of an agent.
Here, the trial court concluded that the joint interest accounting system was not sufficient evidence of an agency relationship to disregard the status of the C corporation. To the court, the fact that the brothers operated the cattle operation through the C corporation, held the C corporation out as the owner to third parties, and enjoyed the limited liability afforded by the legal entity was determinative.
Based on this, the trial court disallowed the brothers expenses for the cattle operation.
Management Entity and Property Holding Entity
On appeal, the brothers argued that the C corporation was merely a management company and that legal title to the cattle remained with the brothers personally.
This arrangement is common in many industries, such as where real estate is held in one entity and the management of the real estate is carried out by another entity. The idea behind this structure is to separate ownership from activities. Then, if the activities generate liability, the liability is limited to the management entity and not the property holding entity.
The appeals court did not accord this argument much weight given that the appeals court felt that this argument was not fully raised at the trial court level and inconsistent with the brothers argument at the trial level (joint accounting only versus day-to-day operations). Absent this procedural issue, it is not clear that the court would have agreed with the management theory. The concurring opinion noted that it agreed with the trial court that the cattle operation was owned by the C corporation.
For families that have several legal entities, care must be taken to document the income and expenses and property held by C corporations. This includes reviewing the relationship between the entities and what each entity does. This issue is even more important given the recent tax rate reductions available to C corporations and the business income deduction that is now available to flow through entities.
With respect to family cattle operations in particular, they should review their joint interest accounting agreements and practices and ownership of cattle to ensure that the items of income and expense are allocated to the proper legal entity. Keeping records of cattle transfers, purchases, and sales is also advisable.