HOLMES, Judge:
Agro-Jal Farming Enterprises, Inc. is a farming corporation in Santa Maria, California that grows strawberries and vegetables. When it harvests them, it uses field-packing materials — plastic clamshell containers for the strawberries and cardboard trays and cartons for the other produce. Agro-Jal has always used the cash method of accounting for these materials — which means that it deducts their full purchase price in the year it buys them instead of deducting them bit-by-bit as they are used. The Commissioner
This is apparently an issue never before addressed by any court.
Agro-Jal was incorporated in 1996, but it is still in many ways the Maldonaldo family farm, whose patriarch founded it many years ago. The business has grown greatly over the years, and most of its income now comes from the efficient production of a few crops — strawberries, broccoli, cauliflower, iceberg and romaine lettuce, and celery. It is a year-round business but somewhat unpredictable because of the farmer's oldest adversary, the weather, as well as fluctuations in market demand.
Strawberry plants can produce several crops before they decline in productivity, so Agro-Jal plants new strawberry plants each October and harvests their fresh fruit between March and June, picks and freezes strawberries between July and August, and passes through the fields for a last crop of fresh fruit a year later between October and December. Broccoli and cauliflower come in throughout the year about 90 to 110 days after planting, and harvesting takes about two weeks at the end of each cycle. Lettuce is more regular: planted each January and harvested about 24 weeks later during a frantic seven days. Celery is also regular, sown in September and October and harvested during May and June.
California's climate lets Agro-Jal stay busy planting and harvesting throughout the year, and once each crop fully matures, Agro-Jal has to be ready with the right combination of trays, cartons, and clamshell containers to pack the produce and get it to market.
Regulations lengthen the lead time for getting field-packing materials out to the field. The labels for all the packing materials must identify the product, its brand name, Agro-Jal's name as the grower and shipper, the country of origin, the weight, the UPC, and other relevant or required information. Agro-Jal can't just buy bare boxes. It must allow enough time to contract for materials that meet all the various federal and state laws on labeling and packaging. This means customization, and Agro-Jal has to wait between two and four months for delivery once it places an order. Agro-Jal buys in bulk and regularly prepays for large quantities to ensure crops don't spoil for want of packaging. This makes it less likely that Agro-Jal will be delayed during the small window in which it must harvest, pack, cool, and ship produce.
One of the complications of deciding these motions is that Agro-Jal uses the cash method for its tax accounting but the
Agro-Jal's year-end records enabled the parties to stipulate the total amount paid for field-packing materials each year, the portion of the costs of those materials bought and used during the year, the portion paid for and received but not used, and the portion that it had paid for but not yet received. (The parties agree that Agro-Jal always received and used any materials in this last category by the end of the next year.) Here's a table for the tax years at issue:
Purchased Purchased Total Total
and not and not Purchased amount amount
Year delivered used and used used purchased
20051 $1,300,000 $554,296 $151,551 $151,551 $2,005,847
2006 2,020,000 467,207 1,280,312 3,134,608 3,767,519
2007 1,770,000 488,124 1,532,927 4,020,134 3,791,051
2008 775,000 486,168 2,073,928 4,332,052 3,335,096
1 Agro-Jal's 2005 tax year isn't at issue here. But we include it because Agro-Jal
bought supplies in 2005 that it didn't use until 2006.
But even though Agro-Jal prepared financing statements using GAAP, it kept its tax accounts — beginning with its first tax year in 1996 and for every tax year afterward — according to the cash method of accounting. Under the cash method, a taxpayer includes all income for the tax year in which it's received, and deducts all expenses for the tax year in which they are paid. See secs. 446(c)(1), 461(a); secs. 1.446-1(c)(1)(i), 1.461-1(a)(1), Income Tax Regs. This means that Agro-Jal deducts the full amount it spends on field-packing materials for the year it buys them, even if it doesn't use them all or even receive them.
The Commissioner concedes that Agro-Jal's packing materials are deductible expenses, and that Agro-Jal is generally entitled to use the cash method. But he challenges the timing of Agro-Jal's deductions.
Both parties have moved for partial summary judgment on this question. There are no factual disputes, and the parties agree that this Court's construction of section 464 and section 1.162-3, Income Tax Regs., will lead to granting one of
Cash-method taxpayers generally can deduct their expenses for the year in which they pay them. See sec. 461(a); sec. 1.461-1(a)(1), Income Tax Regs. And Agro-Jal is surely right that farmers have been allowed to choose the cash method of accounting for a long time. The Supreme Court itself has blessed the practice as "an historical concession by the Secretary and the Commissioner to provide a unitary and expedient bookkeeping system for farmers and ranchers in need of a simplified accounting procedure." See United States v. Catto, 384 U.S. 102, 116 (1966). Farmers have both business and tax reasons to prepay for supplies — they may get to take advantage of earlier deductions, receive more favorable prices, and speed up harvesting. See Commissioner v. Van Raden, 650 F.2d 1046, 1049 (9th Cir. 1981), aff'g 71 T.C. 1083 (1979). There are a few limits — a prepayment must actually be a payment and not a deposit, see, e.g., Lillie v. Commissioner, 45 T.C. 54, 63 (1965), aff'd, 370 F.2d 562 (9th Cir. 1966); Rev. Rul. 79-229, 1979-2 C.B. 210, and the materials or supplies must be used within the next year to avoid an argument about whether the expense needs to be capitalized, see, e.g., Zaninovich v. Commissioner, 616 F.2d 429, 432 (9th Cir. 1980), rev'g 69 T.C. 605 (1978).
As is always the case with tax law, this general rule has a number of exceptions. Two concern us here. The first is section 464, which Congress enacted after noticing that rich people were buying investment packages that featured highly leveraged purchases of farm supplies. These deductions were typically taken by limited partnerships or subchapter S corporations
Section 464 restricts "farming syndicates" from deducting "feed, seed, fertilizer, or other similar farm supplies" earlier than for the year that those supplies are "actually used or consumed." Congress's target was taxpayers primarily motivated by a desire to shelter income — not those motivated by profit. Id. at 58, reprinted in 1976 U.S.C.C.A.N. at 3494. Indeed, the Senate hoped the changes would "improve the competitive position of full time farmers." Id.
Both parties agree that this section does not directly apply to Agro-Jal,
The regulation that's in play is section 1.162-3, Income Tax Regs. (as it was written in the years at issue),
Both parties also analyze what caselaw there is on the subject. Nothing's directly on point, but the Ninth Circuit, to which this case is appealable, see sec. 7482, has spoken a couple times about the timing of farmers' deductions. Both Zaninovich and Van Raden acknowledge that farmers can use cash-method accounting — but that general proposition isn't disputed here. See sec. 1.471-6(a), Income Tax Regs. (expressly authorizing cash-method accounting). And what was disputed in Zaninovich and Van Raden was whether the farmers in those cases could deduct or had to capitalize prepaid rent and feed expenses. The Ninth Circuit created the "one-year rule" to solve that problem: "Under the `one-year
The Commissioner does not argue that Agro-Jal has to capitalize the cost of its field-packing materials, which makes these cases not quite on point. He also points to Hillsboro Nat'l Bank v. Commissioner, 460 U.S. 370 (1983), in support of his position that materials and supplies may be deducted only as they are used or consumed. This case doesn't quite say that, either. Though Bliss Dairy had deducted the full cost of its cattle feed in the same tax year it bought it, and though the Court held in Hillsboro that the dairy's shareholders had to recognize income for receiving in liquidating distributions the feed that the dairy had deducted but hadn't used, the analysis was all about the tax-benefit rule. Id. at 397-402. The tax-benefit rule "tells us to look at the subsequent event * * * and ask: If that event had occurred within the same taxable year, would it `have foreclosed the deduction?'" Maines v. Commissioner, 144 T.C. 123, 129 (2015); see also Rojas v. Commissioner, 901 F.2d 810 (9th Cir. 1990) (argument about tax-benefit rule, not a farm's entitlement to initial deduction), aff'g 90 T.C. 1090 (1988).
The only "subsequent event" here is that Agro-Jal keeps buying and using more field-packing materials every year. And the parties stipulated that Agro-Jal always uses its prepaid packing materials by the end of the following tax year — as it must, because they begin to deteriorate six to eight months after they're delivered. This case is just about the timing of deductions and not about the tax-benefit rule or capitalization-v. -expensing.
The Commissioner argues that Agro-Jal must defer its deductions for field-packing materials until each clamshell, tray, carton, or wrapper is used or consumed. He would italicize the first clause of the first sentence of section
The Commissioner recognizes that tax law usually garnishes general rules with exceptions, but he argues that section 464 is the only exception to this general rule, and that section allows immediate deductions only for "feed, seed, fertilizer, or other similar farm supplies," when the amounts prepaid for these expenses don't account for more than 50% of all farming expenses during any three-year period. See sec. 464(a), (f). Agro-Jal doesn't spend that much on packing materials, but packing materials aren't "feed, seed, or fertilizer," and the Commissioner argues that we should narrowly construe the phrase "other similar farm supplies."
Agro-Jal has two counterarguments. The first assumes that the Commissioner's interpretations of section 464 and section 1.162-3, Income Tax Regs., are correct — that is, section 464 allows immediate deductions only for "feed, seed, fertilizer, and other similar farm supplies" — but Agro-Jal argues that field-packing materials are "other similar farm supplies" and thus deductible in the year of purchase. Its second argument is also textualist, but more complicated. It starts again with section 464 but to make a broader point — that the section's restriction on cash-method accounting for farming syndicates shows that tax law has a background rule that lets farmers who are not syndicates freely use the cash method for everything, at least everything used, as field-packing materials are, within a year. Agro-Jal reasons that section 464 is the only limit that the Code places on farmers' use of the cash method and, because section 464 concededly doesn't apply to it, the Code itself must be read to presumptively allow Agro-Jal to take its deduction for field-packing materials as it normally does — in the year it buys them. Next it tells us to look at the second clause of the first sentence of section 1.162-3 — the one we didn't italicize above: "provided
We'll begin with a close look at section 464. Section 464 sets as a general rule for farming syndicates that "amounts paid for feed, seed, fertilizer, or other similar farm supplies shall only be allowed for the taxable year in which such feed, seed, fertilizer, or other supplies are actually used or consumed." Sec. 464(a) (emphasis added). The negative implication of section 464 is that nonsyndicate farmers, like Agro-Jal, that use the cash method can deduct feed, seed, fertilizer, or other similar farm supplies in the year of purchase. The Commissioner agrees that if Agro-Jal's packing materials are "feed, seed, fertilizer, or other similar farm supplies," then section 1.162-3 doesn't apply.
But the Commissioner doesn't think field-packing materials qualify because, he argues, the old canon of ejusdem generis tells us to limit the reach of "other similar farming supplies" to those like "feed, seed, and fertilizer." He says that means inputs of farm production, not useful materials. Agro-Jal disagrees, and argues that "other similar farm supplies" needs to be read broadly.
When a general word or phrase follows a list of more specific words, ejusdem generis tells us we should narrowly construe the general word or phrase to include only things that are akin to the specific words. See United States v. Tobeler, 311 F.3d 1201, 1205 (9th Cir. 2002); see also Coleman v. Commissioner, 76 T.C. 580, 589 (1981). That list of specific words here — feed, seed, fertilizer — evokes a class. We have to figure out how these terms are alike, and we have to agree with the Commissioner on this one: Feed and seed and fertilizer are alike in that each is an essential input to the growing of crops or the raising of livestock. None of the specified items is useful in any other part of a farm's operations — and specifically not in harvesting, transporting, or marketing. "Feed, seed, and fertilizer" is not an exhaustive list —
But section 464 does bolster Agro-Jal's argument indirectly, because the history of section 464 shows that before its enactment anyone in the farming business could immediately deduct prepaid expenses.
Which brings us to what we think is the real kernel of applicable law on these motions — the first sentence of section
Much depends on the phrase "provided that." Agro-Jal contends that "provided that" is just a lawyerly synonym for "only if." Under this interpretation, Agro-Jal has to defer its deductions until it uses or consumes the field-packing materials "only if" it didn't deduct them in any prior year. Agro-Jal, as a cash-method taxpayer not constrained by section 464, will always have deducted the prepaid materials in the prior year because that's when it paid for them.
Agro-Jal is quite right that historical concessions as supported by references in caselaw, and with clear shadows cast by a section like 464, have created a general rule that farmers can use the cash method for supplies they use within a year of purchase. Agro-Jal even agrees with the Commissioner that section 1.162-3, Income Tax Regs., creates a significant exception to this general rule for materials and supplies. But Agro-Jal also says that this exception doesn't apply to cash-method taxpayers who meet the condition set forth in the "provided that" clause. If a taxpayer has already deducted costs of supplies for a prior year, he's not subject to the first clause. Agro-Jal says the second clause is important to ensure that a deduction is not taken twice by those using the cash method. The first sentence of section 1.162-3 in this reading merely emphasizes the need to bar a second deduction for the same supplies when a taxpayer actually uses them in a later year, but doesn't require taxpayers to defer deductions until consumption. Agro-Jal argues that its interpretation must be correct, because the "provided that" clause would be meaningless if it wasn't read as a conditional limit on the reach of the first clause.
The Commissioner agrees that section 1.162-3 is the controlling regulation here. But he says that the words "provided that" should be read as a "limitation or qualification to prevent a double deduction." He says Agro-Jal's reading of
The Commissioner has to argue in other words that this "provided that" clause doesn't in fact create a condition for the application of an exception, but is doing something else. In an ancient case, Schlemmer v. Buffalo, Rochester & Pittsburg Ry. Co., 205 U.S. 1, 10 (1907), the Supreme Court construed "provided" to create an exception, rather than a condition. We don't think that would make any difference. Whether "provided that" is an exception or a condition, the result is the same here — Agro-Jal would have to defer its packing-materials deduction, except when it already deducted the materials for a prior year. The Commissioner's interpretation is essentially trying to say that "provided that" means "in lieu of." This would require Agro-Jal to take its deductions when the materials are used or consumed "in lieu of" taking them in any prior year.
We think that the Commissioner's reading of the proviso is a stretch and that "provided that" means "on the condition that" or "if" and "with the understanding." See, e.g., Webster's New Collegiate Dictionary 1001 (11th ed. 2008). And we hold that the "provided that" clause of section 1.162-3 means that materials and supplies must be deducted as they are used or consumed, on the condition that (or "only if", or "as long as") they haven't been deducted in any prior year. A cash-method taxpayer who immediately deducts supplies in the year of purchase will satisfy the first sentence of section 1.162-3 by not taking a second deduction when the materials or supplies are used in a later taxable year.
Each side warns us that the other's reading of the phrase would create surplusage. The surplusage canon holds that "it is no more the court's function to revise by subtraction than by addition" and most commonly prevents a statutory interpretation that would make a provision irrelevant. Antonin Scalia & Bryan A. Garner, Reading Law: The Interpretation of Legal Texts 174, 176 (2012).
We agree with Agro-Jal. Agro-Jal's interpretation of section 1.162-3 could apply in three different scenarios. In the first a packing producer advances a cash-method taxpayer materials and supplies without immediate payment. Let's say that in December of year 1, a cash-method farmer receives and uses $100 of supplies payable 30 days later in January of year 2. Generally, under the cash method, the farmer would ordinarily deduct the supplies for year 2 — the year he paid for them. See sec. 1.461-1(a)(1), Income Tax Regs. But under Agro-Jal's reading of section 1.162-3 the farmer can deduct the supplies in year 1 — the year he used them. In this example, Agro-Jal's reading of section 1.162-3 permits deductions in the earliest possible year, without deferral or duplication.
But there's another wrinkle — section 1.162-3 doesn't say "any" or "all" materials and supplies. It instead governs only materials and supplies that taxpayers carry "on hand." Let's go back to the block quote for a fourth time, with yet another bit italicized:
The first question is what "on hand" means. Agro-Jal says it includes materials and supplies that are prepaid and have been delivered but haven't yet been consumed. Materials and supplies that have been ordered, but haven't yet been delivered, are not "on hand." The Commissioner takes a much more expansive view: He says "on hand" includes items that've been purchased and are expected to arrive at a later
More important is how the phrase "on hand" affects the meaning and scope of section 1.162-3. Section 1.162-3 governs only materials and supplies "on hand." Materials and supplies not on hand do not seem to be governed by section 1.162-3 at all. And this means that the regulation cannot under any plausible reading say exactly what the Commissioner argues — namely, that Agro-Jal can't deduct any of the field-packing materials that it has paid for and not yet used.
Agro-Jal can deduct its field-packing materials for the year it bought them. The materials that it buys that are not "on hand" are governed by the general rules of cash-method accounting, which allow current deduction. The materials that it buys that are "on hand" are governed by section 1.162-3, which we hold does not require a cash-method taxpayer to defer its deductions until the materials are used or consumed, if the taxpayer deducted their costs for a prior tax year. The "one-year rule" — the rule that a taxpayer has to use those supplies within an approximately one-year period — might limit deductibility in some other case.
An appropriate order will be issued granting petitioners' motion and denying respondent's motion.
The Commissioner and Agro-Jal agree that Agro-Jal does not fall under section 464(c) and (f).
Those year-end inventories also serve as a "record of consumption" of the firm's field-packing materials: Agro-Jal says that it doesn't keep a record of consumption of each field-packing item. But it's possible to compute consumption by taking inventory at the beginning of the year, adding new purchases, and subtracting inventory at the end of the year. Agro-Jal did keep records of each of those parts of the consumption equation, which means that it kept a record of consumption, and so fails the first italicized requirement.
