When Bidding Is Not Marketing

I was talking with a client recently. He is a real estate developer, and he was telling me about a tense run-in several years ago with the county about a proposed development. Think NIMBY (not in my backyard) and you have the context.

Believe it or not, there is a tax issue there.

Let’s set it up by discussing Hisham Ashkouri (HA).

HA was an architect. He was bidding on projects in Washington state and Utah. He was also bidding on projects in Libya and in the Republic of Tartarstan, which is in Russia.

Those last two are certainly off the beaten path.

Using different companies, he submitted development bid proposals. I am not sure what was in these bid proposals, but over three years (2009 – 2011), he deducted over $500 grand in bid expenses.

Sounds expensive.

The IRS audited the three years.

And disallowed the bid expenses.

That doesn’t sound right, thought I.

HA argued that he had deducted marketing and promotion expenses.

Then HA went foot-in-mouth:

“If any of those projects had resulted in ‘a real estate transaction …, I would be having 20 percent ownership.’”

Let’s introduce Code Section 263A. That bad boy generally deals with the acquisition of property, and its intention is to make you capitalize everything under the sun when you acquire – including constructing or developing – property. “Capitalize” is accounting-speak for depreciating something rather than deducting it immediately.

If you depreciate over one year, then I suppose the net effect is approximately the same. If you have to depreciate over 39 years, well, it is going to hurt.

HA fired off first and strong:

The deductions …"could not be capitalized as they were used for marketing and promotion with no real estate transaction." Although petitioners fail to cite any authority in support of that claim, they are correct that section 263A does not require the capitalization of "marketing, selling, advertising, and distribution costs." 

The Court however nailed the issue:

Mr. Ashkouri's testimony regarding the projects he pursued was not particularly detailed, but we take him as having acknowledged that, had he been awarded any of the projects, he would have acquired an ownership interest in the property being developed. He did not identify any project for which he claimed deductions in which he would not have received an ownership interest had he been awarded the contract.”

Every project would have resulted in the acquisition of an ownership interest. This is not marketing or promotion in a conventional sense. HA’s possible ownership interest at the end lands these transactions within the Section 263A dragnet.

So what? He did not win any of these bids, and he would get to deduct the bid costs when the contract was awarded to someone else. Granted, the deduction might be held-up a year or two – until the bid was awarded – but HA would eventually get his deduction.

Here comes the Scooby Doo mystery portion of the case:

But petitioners have not established when (if ever) the development contracts Mr. Ashkouri sought were awarded to others, when Mr. Ashkouri received written notice that no contract would be awarded, or when he abandoned his bid or proposal for each project.”

Seriously? He could not show that the bid went to someone else or was withdrawn entirely? I am not getting this at all.

The Tax Court then backed-up and ran over the body a second time – apparently to make sure that it had stopped breathing:

Even if we were to accept that the expenses in issue were not subject to deferral under section 1.263A-1(e)(3)(ii)(T), Income Tax Regs., we would still conclude that respondent properly disallowed the deductions for architectural or contract services claimed on the Schedules C for Mr. Ashkouri's proprietorship because petitioners did not adequately substantiate the expenses underlying the claimed deductions. In general, section 162(a) allows a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business". When called upon by the Commissioner, however, a taxpayer must substantiate his expenses.”

Bam! Even if HA provided evidence about the bid outcomes, the Court was still going to say “No.”

Back to my real estate guy.

What was the tax issue back when?

His transaction involved real estate development. There is no question that he would have had an ownership interest if the project went through; in fact, he would be the only owner.

Let’s say he incurred significant expenses – legal, engineering and the like – while battling the county.

Would have had to capitalize those expenses rather than deduct them right away?

Almond Not-Joy

How much do you know about almond trees?

I know they are water-intensive and they come from California. I am uncertain whether they can be used for furniture. I presume they make good firewood.

So what would be a tax angle to this topic?

Growing almond trees.

Which gets us to farm taxation.

Farmers want (usually) to be cash-basis. This means that they report revenue when they receive cash and deduct expenses when they pay cash. It makes for relatively easy accounting, as one can almost get to a tax return from adding together 12 bank statements.

Then there are those issues.

I will give you one:

You buy a tractor-trailer load of seed and fertilizer late in December. Can you deduct it?

The issue here is whether you have incidental or nonincidental supplies. Incidental supplies (think printer paper to an accountant’s office) is deductible when purchased. Nonincidental supplies (think refilling an underground fuel tank of a trucking company) might be deductible only when used and not before.

Spend some big bucks on that fuel and the trucking company is keenly concerned about the answer.

Likewise, spend big bucks on seed and feed and the farmer is also keen on the answer.

Farmers have some nice tax bennies in the Code, and a large one is being able (in many cases) to use the cash basis of accounting. The Code furthermore allows farmers to deduct that year-end seed-and-feed (with some limitations) when purchased.

Nice.

That covers a lot of tax territory for row crops (that is: one growing season).

Let’s go next to orchards. Apples. Pears.

Almonds.

What new issue do we have here?

For one, orchards take years to become productive. There is no crop in the early years.

Is there any difference in the tax treatment?

Yep. It’s a sneaky one, too.

Let us talk about “uniform capitalization.” We have touched on this topic before, but never concerning almond trees. I am pretty sure about that.

The idea here is that the tax Code wants one to capitalize (that is, not immediately deduct) certain costs associated with inventory, self-produced assets any certain other specialized categories.

Almond trees are sort-of, kind-of “self-produced.”

Here is the fearsome tax beast in its canopied jungle home:

26 U.S. Code § 263A - Capitalization and inclusion in inventory costs of certain expenses

            (a) Nondeductibility of certain direct and indirect costs

(1) In general In the case of any property to which this section applies, any costs described in paragraph (2)—

(A) in the case of property which is inventory in the hands of the taxpayer, shall be included in inventory costs, and

(B) in the case of any other property, shall be capitalized.

I would argue that almond trees are “other property” per (a)(1)(B) above.

(2) Allocable costs The costs described in this paragraph with respect to any property are—

(A) the direct costs of such property, and

(B) such property’s proper share of those indirect costs (including taxes) part or all of which are allocable to such property.

Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.

The (B) above worries me. If this applies, then we have to “capitalize” real estate taxes on those trees.

Let’s look further at the definition of “property”:

(b)Property to which section applies Except as otherwise provided in this section, this section shall apply to—

(1) Property produced by taxpayer

Real or tangible personal property produced by the taxpayer.

(2) Property acquired for resale

(A) In general

Real or personal property described in section 1221(a)(1) which is acquired by the taxpayer for resale.

OK, I am getting worried. That (b)(1) sounds a lot like the almond trees. They are being “produced” (I guess) while they are growing and nonproductive.

Is there an out?

Here is something:

            (d)Exception for farming businesses

(1) Section not to apply to certain property

(A)In general This section shall not apply to any of the following which is produced by the taxpayer in a farming business:

(i) Any animal.

(ii) Any plant which has a preproductive period of 2 years or less.

I am zeroing-in on (d)(1)(A)(ii).

What is the growing (“preproductive”) period for almond trees?

Google says more than 2 years.

We are hosed.

We have to capitalize real estate taxes. 

COMMENT: Folks, that means “not deduct.” It gets expensive fast.

You know what else gets pulled-in via the gravitational pull of Sec 263A(a)(2)(B) above?

Interest.

We better not have any bank debt.

Arrggghhh! We have bank debt, meaning we have interest. We are going to have to capitalize that too.

The way this is going the only thing we are going to be able to deduct is the postage for the envelope in which we are sending a big check to the IRS.

We began the discussion by talking about how the cash basis of accounting lets farmers deduct stuff when they pay for them. Then we marched through the Code to find another section that tells us that we cannot deduct what we could deduct only a moment before.

COMMENT: I have heard a common lament over my years in practice: when to stop researching? There is no hard answer, but this case is an example of why tax practitioners fear and ask the question.

Our case this time was Wasco Real Properties I, LLC et al v Commissioner, for the home gamers.

Kentucky, Bourbon and Tax Accounting

I came across a proposed tax bill that caught my eye.

It has to do with bourbon.

Bourbon is closely associated with Kentucky, as the state produces approximately 95% of the world supply. I have heard that there are more barrels of bourbon aging in Kentucky than there are residents (of which I am one). I do not know if that is true, but it does summarize the importance of the industry to the commonwealth.

So Kentucky senators and representatives have introduced a tax bill to exempt bourbon producers from the interest capitalization rules.

This is relatively old tax law, having entered the Code in 1986. It caused practitioners quite a bit of problem at start-up (I was a young CPA), but for the most part it has settled down since.

The explanation for the law was to bring consistency to inventory tax accounting. By itself that was laudable, but the law went further. Congress also decided that certain costs associated with a manufacturing or production process were not being appropriately captured by generally accepted accounting principles (GAAP). To correct that accounting oversight, the tax Code would henceforth require the capitalization of costs not previously capitalized on financial statements.

In accounting-speak, “capitalizing” means removing an expense from net income by putting it (that is, by “capitalizing” it) on the balance sheet as an asset. It can remain there for six months, fifteen years or until the end of time, depending upon. The common result is that it is not an expense on the income statement. Extrapolate that and it probably is not a deduction on the tax return.

You can see Congress’ fascination with becoming tax accounting experts.

This tax provision is referred to as uniform capitalization, or - for the hard core – Section 263A, which is the Code section that houses it. Most of the accountants I have worked with consider uniform capitalization little more than a slight-of-hand (and other earthier words) to increase taxes on inventory-intensive businesses.

Let’s be blunt: if there were issues with the inventories of Kimberley-Clark or Proctor & Gamble, the resulting lawsuits would have self-corrected the matter years ago.

Interest expense is one of the costs that have to be capitalized under Section 263A.

A perfect tax trap would be an expensive inventory which takes many, many years to get to market. One would have to capitalize interest every year. Granted, there would be a tax deduction down the line when the inventory was sold, but the wait to get there could get expensive.

What would be an example of such an inventory?

Well, bourbon.

Some high-end bourbons are aged for a long time. Take a personal favorite – Pappy Van Winkle Family Reserve 15 Year. It has a 20-year brother, but many aficionados consider the 15 a better product. There are bourbons aged even longer. That is a lot of years to carry an inventory.

The problem is that many bourbon competitors do not have this tax issue. Consider rum or vodka, for example, with a short ageing process.  Scotch whisky would be comparable, but the UK does not have an equivalent to Section 263A. This means that scotch producers do not have the tax problem of their US bourbon counterparts. Wine production would be comparable. Perhaps the Kentucky delegation could join forces with their California peers on this matter.

But why exempt bourbon producers but not others adversely affected by interest capitalization?

It is a fair question.

To which there is a fair answer: if international accounting firms are willing to be sued for the amount of inventory shown on audited financial statements, should we not presume that number is substantially correct? Why then does the Code require another calculation of inventory for the tax return?

We know why. It is the same as you losing a credit for your kid’s college tuition because you make enough money to send your kid to college. The tax Code is riddled with these things. Interest capitalization is a clever backdoor, however, as it dives into tax accounting itself. This area is arcane and boring and likely to keep someone from looking too closely. That is – of course – why it was done.