Estate of Steve K. Backemeyer, Deceased, Julie K. Backemeyer, Personal Representative, and Julie K. Backemeyer v. Commissioner of Internal Revenue, 147 T. C. 17 (2016).

In Estate of Backemeyer, the U. S. Tax Court ruled that the tax benefit rule does not require recapture of deductions claimed by a deceased farmer for farm inputs upon his death, even when those inputs are subsequently used by his surviving spouse. Steve Backemeyer, a cash-method farmer, deducted 2010 expenses for farm inputs he intended to use in 2011. He died before using them, and his wife Julie used them in her farming operation in 2011. The court’s decision clarifies the interaction between estate tax, basis step-up, and income tax deductions, ensuring no double taxation occurs.

Parties

The petitioners were the Estate of Steve K. Backemeyer, Deceased, with Julie K. Backemeyer as the Personal Representative, and Julie K. Backemeyer individually. The respondent was the Commissioner of Internal Revenue.

Facts

Steve K. Backemeyer and Julie K. Backemeyer were married and resided in Greenwood, Nebraska. Steve operated a farming business as a sole proprietor using the cash method of accounting. In 2010, Steve purchased various farm inputs, including seeds, chemicals, fertilizers, and fuel, which he intended to use for the 2011 crop year. He deducted these expenses on his 2010 Schedule F, Profit or Loss From Farming. Steve died on March 13, 2011, without having used any of the purchased farm inputs. These inputs were transferred to the Backemeyer Family Trust, with Julie as a trustee. Julie, who began her own farming business as a sole proprietor upon Steve’s death, took an in-kind distribution of the farm inputs and used them to grow crops in 2011. Julie deducted the value of these farm inputs on her 2011 Schedule F.

Procedural History

The Commissioner of Internal Revenue determined a deficiency of $78,387 in the Backemeyers’ federal income tax for tax year 2011, along with an accuracy-related penalty of $15,864 under I. R. C. sec. 6662. The Backemeyers filed a petition in the U. S. Tax Court to contest these determinations. The case was submitted fully stipulated for decision without trial. The Commissioner initially advanced several arguments but later narrowed his position to focus solely on the applicability of the tax benefit rule. The Tax Court’s decision was appealable to the Court of Appeals for the Eighth Circuit.

Issue(s)

Whether the tax benefit rule requires the recapture upon Steve Backemeyer’s death in 2011 of deductions he claimed for 2010 for his expenditures on farm inputs?

Whether the accuracy-related penalty under I. R. C. sec. 6662 for a substantial understatement of income tax applies in this case?

Rule(s) of Law

The tax benefit rule requires a taxpayer to include a previously deducted amount in their current year’s income when an event occurs that is fundamentally inconsistent with the claimed deduction for the previous year. I. R. C. sec. 1014 provides a step-up in basis for property acquired from a decedent to its fair market value at the date of death. I. R. C. sec. 162 allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. I. R. C. sec. 6662 imposes an accuracy-related penalty for a substantial understatement of income tax.

Holding

The Tax Court held that the tax benefit rule does not require the recapture upon Steve Backemeyer’s death in 2011 of deductions he claimed for 2010 for his expenditures on farm inputs. The court also held that the accuracy-related penalty under I. R. C. sec. 6662 for a substantial understatement of income tax does not apply, given that the Backemeyers’ deductions were appropriate, and the sole denied deduction conceded by the Backemeyers was not large enough to merit imposition of the penalty.

Reasoning

The court applied a four-part test from Frederick v. Commissioner, 101 T. C. 35 (1993), to determine the applicability of the tax benefit rule. The court found that Steve Backemeyer’s death and the subsequent use of the farm inputs by Julie were not fundamentally inconsistent with the premises on which the initial deduction was based. Had Steve died in 2010 and Julie used the inputs that same year, Steve would still have been entitled to the deduction. Additionally, the estate tax effectively recaptures I. R. C. sec. 162 deductions by taxing the inputs at their fair market value at the time of Steve’s death, thus obviating the need for the tax benefit rule to apply. The court also noted that the nonrecognition provisions of I. R. C. secs. 102 and 1014, which govern the treatment of gifts and legacies, prevent the application of the tax benefit rule in this case. The court concluded that Congress’s provision for and maintenance of a stepped-up basis under I. R. C. sec. 1014 was a deliberate choice to prevent double taxation. Regarding the accuracy-related penalty, the court determined that the understatement of income tax was limited to the tax on the $203 deduction for custom hire, which was conceded as improper by the Backemeyers, and was not substantial enough to warrant the penalty under I. R. C. sec. 6662.

Disposition

The Tax Court’s decision was entered under Rule 155, affirming the Backemeyers’ deductions except for the $203 deduction for custom hire, which was conceded as improper.

Significance/Impact

This case clarifies the interaction between the tax benefit rule and estate tax in the context of farm input deductions. It establishes that the tax benefit rule does not apply to recapture deductions for farm inputs upon the death of a taxpayer when those inputs are subsequently used by the taxpayer’s heir. This decision is significant for cash-method taxpayers in agriculture, ensuring that the estate tax’s operation prevents double taxation. The case also reinforces the principle that Congress’s provision for a stepped-up basis under I. R. C. sec. 1014 is intended to prevent double taxation, as noted by the Court of Appeals for the First Circuit in Levin v. United States, 373 F. 2d 434 (1st Cir. 1967). The ruling’s impact extends to the application of accuracy-related penalties, demonstrating that a conceded small deduction does not constitute a substantial understatement of income tax under I. R. C. sec. 6662.