Part of the fun of being a tax lawyer (especially for us old enough to remember Mad Magazine) is being able to watch the “spy vs. spy” battle that plays out in tax litigation.  We enjoy watching taxpayers employ provisions of the Tax Code in ways that may not have been in Congress’ collective mind when it wrote the provisions.  In some cases, the IRS challenges a taxpayer’s use of provisions clearly intended to benefit the taxpayers.  One such case is the recent Fifth Circuit decision:  Burnett Ranches, Ltd. V. United States, No. 13-10403, issued on May 23, 2014.  Burnett Ranches involved a family owned, stereotypical Texas working livestock ranch that had been operated continuously by the descendants of Captain S. B. Burnett for more than 150 years (the ranch was founded after the Alamo fell and before shots were fired on Fort Sumter).

The current Burnett descendent running the ranch is the colorfully named grand dame: Anne Burnett Windfohr Marion. The ranch is owned through a limited partnership, a trust and an S Corporation.  The issues were (i) whether the ranch was a “farming syndicate” tax shelter, which would be required by Section 464 to use the accrual method of tax accounting, and (ii) whether the taxpayer and the ranch qualified for the Active Participation Exception of Section 464(c)(2)(A).  This exception applies to an interest in a farming entity held by an individual who has actively participated (for five or more years) in the management of the entity.

Congress enacted Section 464 to attack the practice of  acquiring  an agricultural business that had large tax operating losses using a pass-through entity and  then selling interests in the entity to sophisticated passive “investors” who had nothing to do with farming, but who had lots of taxable income to shelter.  As an exception to this anti-tax shelter provision, Congress carved out individuals, families and entities legitimately and directly engaged in agricultural enterprises.  In Burnett Ranches, the issue was whether the  ranch was subject to the anti-tax shelter provisions of Section 464 (because it was owned by high-income, non-farmer investors) or whether the Active Participation Exception applied (because the ranch was owned by bona fide farmers like Ms. Marion).

The federal district court decision denied the government’s motion for summary judgment (that Ms. Marion’s participation through her S corporation did not qualify for the Active Participation Exception) and granted Burnett Ranches’ cross-motion on that issue, but the District Court postponed the effect of its decision to allow for additional discovery regarding Ms. Marion’s active participation.  Following additional discovery, the Government conceded that Ms. Marion herself did indeed actively participate in the ranch’s farming business.  But the Government stubbornly maintained that the Active Participation Exception did not apply because Ms. Marion did not own her interest in the ranch directly, but through her S Corporation which was a limited partner in the ranch entity.

On appeals, the Fifth Circuit, following the District Court’s lead, found that the language of Section 464 was to be read broadly and that the Active Participation Exception was to apply not only to interests in a farming operation owned directly by the participating taxpayers, but also to interests held indirectly.  An otherwise qualified individual who has participated in managing a farming operation qualifies for the Active Participation Exception, “irrespective of the fact that the legal title of such individual’s attributable interest happens to be held in the name of her wholly owned S Corp, rather than in her own name.”

Of particular interest is the Court’s harsh characterization of the Government’s position as a “last-ditch, ‘Gotcha’ contention that the interposition of Ms. Marion’s S Corp between her and Burnett Ranches stymies the latter entity from qualifying for the Active Participation Exception.”  The Court further noted that the taxpayer’s position would be exactly the same vis a vis the use of the cash method of tax accounting with or without the S Corporation being in the chain of title.  The court chastised the Government for pursuing its position that legal title in the S Corporation prevented application of the Active Participation Exception, after conceding that Ms. Marion was an active participant in the farming operations. The Court viewed this as a “slender reed” upon which to prop up the Government’s weak argument.

The Court based its ultimate decision in favor of the taxpayer on the wording of Section 464 and normal rules of statutory construction. Accordingly the taxpayers were not required to use the accrual method of accounting with respect to Burnett Ranches.

It is refreshing to see the Fifth Circuit Court of Appeals use such a common-sense approach to prevent the IRS from unfairly applying hyper-technical arguments to prevent taxpayers from taking advantage of the cash method of accounting for a farming operations which clearly seems to be what Congress intended.  In other areas of the law we have seen the IRS take positions that seem to fly in the face of what Congress intended[1].  Maybe this and other recent cases in the Circuit Courts of Appeals will serve to reign in such aggressive and anti-taxpayer positions.