Fifth Circuit Clarifies the “Active Participation” Exception to the Internal Revenue Code’s Farming-Syndicate Rules

Recently, the United States Court of Appeals for the Fifth Circuit handed down some good news for individual cattle ranchers and farmers wishing to take advantage of S corporations for tax purposes, yet seeking to avoid having their business operations classified by the IRS as an impermissible tax shelter.  In Burnett Ranches, Ltd. v. United States, — F.3d —, No. 13-10403, 2014 WL 2142112 (5th Cir. May 22, 2014), the Fifth Circuit examined the definition of “farming syndicate” set out in section 464 of the Internal Revenue Code and concluded that:

 “an otherwise qualified individual who has participated in management of the farming operations for not less than five years comes within the Active Participation Exception embodied in § 464(c)(2)(A), 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.”

Id. at *7.

To appreciate the significance of this holding, a brief overview and history of the farming-syndicate rules may prove helpful.  A farming syndicate, generally speaking, “is a tax-shelter arrangement whereby a farmer with tax losses sells a partnership interest in the farm to a high-income individual taxpayer who has no genuine interest in farming, with the purpose of providing the taxpayer loss deductions on his federal income-tax return.”  Burnett Ranches, Ltd. v. United States, No. 4:11-CV-562-Y, 2012 WL 10928475, at *3 (N.D. Tex. Oct. 24, 2012) (Means, J.) (citing Estate of Wallace v. C.I.R., 965 F.2d 1038, 1040–44 (11th Cir.1992)).  This is the “tax loophole that Congress sought to close in adopting § 464.”  Burnett Ranches, 2014 WL 2142112, at *3.

At the same time, however, Congress did not wish to prevent individuals, families, and entities that had “bona fide interests in agricultural endeavors” from enjoying the tax benefits that farmers had previously been able to enjoy, such as claiming deductions on their federal income-tax returns based on the cash-receipts-and-disbursements method of accounting.  Id.  Accordingly, Congress added subsection (c)(2) to identify and define certain classes of taxpayers whose interests in farming operations should be exempted from the treatment given to the interests of tax syndicates.  See id.

One such exemption, set out at subsection (c)(2)(A), attaches to “any interest” in a partnership or similar enterprise that is “attributable to” the active participation of an individual in the management of a farming business or trade for not less than 5 years.  See 26 U.S.C. § 464(c)(2)(A).  This is the exception that the individual taxpayer in Burnett Ranches was hoping to utilize.  The government had argued that the taxpayer’s interest did not fit within this “active participation” exception because the interest was not held directly by the individual tax payer but rather through an S corporation that the taxpayer wholly owned.

At the trial level, United States District Judge Terry R. Means rejected the government’s argument, observing that “the language of subsection 464(c)(2)(A) does not restrict application of the active-participation exception to indviduals. Rather, the statutory language indicates that the exception applies to any interest in a partnership that is attributable to an individual’s active participation in the management of a farming business for [five years or more].”  Burnett Ranches, 2012 WL 10928475, at *4.

On appeal, the Fifth Circuit affirmed and emphatically agreed with Judge Means’s conclusion that “[t]his interpretation of Section 464(c)(2)(A) maintains consistency with the purpose of the farming-syndicate rules without needlessly expanding their scope.”  Burnett Ranches, 2014 WL 2142112, at *3 (quoting Burnett Ranches, 2012 WL 10928475, at *5).  Congress, explained the Court, “did not intend to deprive genuine farmers or ranchers of their previously enjoyed tax benefits.”  Id.

In light of this recent decision, then, otherwise qualified cattle ranchers and farmers in Texas, Louisiana, and Mississippi who have participated in management of the farming operations for not less than five years may come within the active-participation exception set out in subsection 464(c)(2)(A) even though their attributable interest is held through a wholly owned S corporation rather than in their own names.