SBA: - Office of Advocacy -Letter dated 11/21/97 - Internal Revenue Service - Comments regarding proposed amendments to the Income Tax Regulations related to expenses incurred in connection with property produced in a farming business. 62 Fed. Reg., 44,542, August 22, 1997.

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November 21, 1997

Honorable Charles O. Rossotti
Commissioner
Internal Revenue Service
1111 Constitution, Ave. NW
Room 3000
Washington, DC 20224

re: CC:DOM:CORP:R (REG-208151-91)
Comments regarding Rules for Property Produced in a Farming Business under IRC263A

Dear Commissioner Rossotti:

The following comments are submitted regarding proposed amendments to the Income Tax Regulations related to expenses incurred in connection with property produced in a farming business. The regulations apply section 263A of the Internal Revenue Code (IRC)

On August 22. 1997, the Internal Revenue Service (IRS) published a notice of proposed rulemaking (proposed rule) in the Federal Register (62 FR 44607) and also published a Final and Temporary Regulations (62 FR 44542) on the same subject, effective on the date of publication, August 22, 1997. The regulations are intended to clarify existing law and regulations. In the text, the IRS indicates that it did not analyze the impact of the regulations on small entities as required under the Regulatory Flexibility Act (RFA) (1)finding instead that the proposed new regulations are interpretative and require no new information collection by the taxpayer and therefore not subject to RFA.

We believe an analysis should have been done. The conflicts that have arisen in the enforcement of capitalization rules in the nursery industry should have alerted the IRS that specialized knowledge and particular care were necessary to avoid confusion. The proposed regulations would have the effect of requiring nurseries to keep detailed records of plants held for "growth and further cultivation" in order to justify their decision to deduct or to capitalize expenses incurred in connection with the plants. Before the proposed rule, these industries were not required to keep such records.

These comments are submitted pursuant to section 7805(f) of the IRC(2)and also under general authority of the Office of Advocacy to monitor Agency compliance with the Regulatory Flexibility Act (RFA)(3) as amended by the Small Business Regulatory Enforcement Fairness Act (SBREFA). (4)Additionally, the Small Business Act (5) authorizes the Office of Advocacy to represent the interests of small businesses before federal agencies. The views expressed by the Office of Advocacy are its own and do not necessarily reflect the position of other federal agencies.

The Office of Advocacy is aware that the IRS has received hundreds of comments challenging the merits of the proposed regulation and has held a hearing on the difficulties the nursery industry believes the regulation as written will present. The Office of Advocacy will focus its comments primarily on the applicability of the RFA to the proposed rule.

Applicability of the Regulatory Flexibility Act

The 'Special Analyses' section of the proposed rule states as follows:

"It also has been determined that section 553(b) of the Administrative Procedure Act (APA)(5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S. C. chapter 6) does not apply."

The IRS has thus made the decision that the rule is interpretative and that no collection of information requirement is imposed on the small businesses which would fall under this regulation. In this case, the Office of Advocacy disagrees with this conclusion.

A "rule" that is subject to the RFA is any rule "for which the agency publishes a general notice of proposed rulemaking pursuant to section 553(b) of the APA or any other law."(6) Section 553(b) of the APA provides, "…Except when notice or hearing is required by statute, this subsection does not apply- (A) to interpretative rules..." The IRS has steadfastly maintained over the years that the vast majority of its rules are interpretative rules and therefore not subject to the APA or the RFA as they claim in this proposed regulation.

Information Collection Requirement:

In 1996, Congress amended the RFA with the SBREFA which provides that an analysis still should be done "to the extent that such interpretative rules provide a collection of information requirement". "Collection of information" is defined to include "recordkeeping requirements," which are defined as a "requirement imposed by an agency on persons to maintain specified records."(7)

Congress expressed its intent that the analysis requirement be construed broadly in the Statement of the Managers which accompanied SBREFA:

"One of the primary purposes of the RFA is to reduce the compliance burdens on small entities wherever possible under the statute. To accomplish this purpose, the IRS should take an expansive approach in interpreting the phrase "collection of information" when considering whether to conduct a regulatory flexibility analysis."(8)

In the case at hand, the rule clarifies the farming business deductions (IRC 263A(d))do not apply to a taxpayer who merely buys and resells plants…raised by another. It then lists factors that will be considered in deciding who can use the deduction.

This is a major issue which would have widespread impact, particularly on the nursery growing industry which has been the subject of considerable legislative and regulatory debate over the past 40 years over their ability to deduct their costs. Under the law and IRS regulations, if a nursery is defined as a farming business, then it may deduct the costs of purchasing seeds, saplings and certain other pre-production costs. If however, the nursery is determined to merely hold plants for resale, then it must inventory the plants and capitalize the costs attributable to them in order to exclude that portion from taxable income when the plant is sold. Qualifying under the definition of farming business is very important to nurseries.

The IRS has seemed mindful of the impact of this definition and stated flatly during the hearing on the proposed regulation that it was not the IRS' intent to apply capitalization rules to anyone who was growing or further cultivating plants. Nonetheless, if nurseries do not receive a blanket exemption, they must be ready to prove their intent to hold the plants for growth and further cultivation. The factors mentioned in the preamble accompanying the regulation include: "the length of time between the taxpayer's acquisition of a plant and the time the plant is made available for sale to the taxpayer's customers, and in the case of plants, whether the plants acquired by the taxpayer are planted in the ground or kept in temporary containers."(9)

The regulation and its explanation puts new limits on what will be considered a farming business for tax purposes. Any nursery that buys and sells plants grown by another nust now collect and keep such records and information as will permit them to establish for a revenue agent how long they kept a plant before resale, how they cultivated it when it was kept, whether it was in a temporary container and what was the final disposition of the plant. Without such information, a nursery may not be able to satisfy the IRS that the plant was kept for growth and further cultivation. It is evident from the enforcement history in this industry that this issue is a recurring problem.

The Office of Advocacy anticipates that the IRS might contend that nothing in the regulations compels recordkeeping but the Office of Advocacy believes the new stricter standard imposes a de facto recordkeeping requirement. As such, SBREFA requires the burden on small business to be analyzed with an opportunity for the public to comment on the analysis.

Significant Impact on a Substantial Number of Small Entities

This new requirement will have a significant impact on those who must comply with it, such as nurseries, even if the IRS did not intend one. At the hearing, it was made clear that nurseries currently note their expenses which they then list for deductions. Under the proposed regulation, a nursery will be required to maintain records on individual plants. Whether they qualify for deduction depends on what purpose is attached to each plant, how it is kept and what is actually done with it. Without the presumption that their pre-production expenses were deductible, the businesses need to be able to establish: a) how long they kept the plants; b) whether they were in temporary containers, and; c) what costs were related to each plant (in the event they are disqualified from the deduction.)

It is also clear that the proposed regulation would affect a substantial number of small businesses. The Department of Agriculture reports that there are about 20,000 nurseries nationwide. (Other industries also may be impacted by this rule.) Even if only a fraction of those receive plants in temporary containers for further growth and cultivation, it still could be substantial. Nursery industry representatives testifying before the IRS, maintained that their surveys of the industry indicated that the vast majority of nurseries buy at least some plants in temporary containers which they grow and cultivate further. From this testimony, we conclude that a conservative estimate of the affected nurseries would be at least 10,000 small businesses (a simple majority of the nursery category).

Without addressing the question of whether the IRS is right or wrong on the construction of the regulation, we conclude that the proposed regulation (and the temporary and final regulations that were issued in unison with it), impose a new collection of information requirement and that the regulations will have a significant impact on a substantial number of small businesses.

Conclusions:

We believe that the IRS' intentions were good with regard to the clarification of this regulation but that the proposed regulation has unforeseen implications. During the hearing, the IRS maintained that the comments were out of proportion to what the IRS actually intended by the new interpretation. They surmised that a correction probably could have been accomplished with a phone call rather than filing comments and issuing statements. In response to that, one of the witnesses said that while this is true, the industry and others who are regulated feel that the phone call should have come from the IRS rather than the other way around. The nurseryman who testified read a highly technical but key portion of the regulation and expressed his concern that the language was incomprehensible to him: he felt he would never be able to fully understand what it meant without a lawyer.

These examples capture the essence of taxpayer frustration with the IRS and agencies in general. They also embody the spirit of the Regulatory Flexibility Act and the Small Business Regulatory Enforcement Fairness Act. The regulating agency should involve the regulated earlier and should make s stronger effort to help them understand what it means. The RFA provides a good procedure for accomplishing that goal.

The Office of Advocacy also would like to point out that it might help the regulatory process if the RFA were not routinely circumscribed with boilerplate language but, instead was embraced by the IRS. It is obvious from regulatory drafting that a great many talented and thoughtful people put a great deal of time and effort into drafting regulations which small businesses need. It is also obvious in some cases, that a lot of research was done on these groups that were regulated before the new regulations were drafted. That being the case, this research needs to be shared with those who could add insight into the impact of the regulations. In the case at hand, an analysis probably would have shown that: a) there is a history of difficulties with this area, b) that the nursery industry and perhaps others do business in a way which makes bright line tests and consistent enforcement difficult, c) that a slight tightening in the way the rules are defined will cause prudent nursery owners to greatly increase the records they keep on individual plants; and finally, d) that at least one IRS field office has already canvassed the nursery industry to develop industry audit guidelines which would have been very useful in drafting regulations.

The analysis should inform the regulators and the business community about the potential impact of the proposed rule. For these reasons, we strongly recommend that the IRS do an analysis of the impact of its proposed regulation to become better informed of the impact of the regulation and to inform the regulated community what is being proposed. The analysis should include information on how many and what kinds of businesses would be effected by the regulations; how much it will cost if they are required to inventory each plant to document time kept; the type process on the plants that qualify (for example, watering a plant that is on a shelf for sale is presumed not to constitute farming) container; and other elements to establish that they are holding the plant for further growth and cultivation. Finally the IRS should consider alternatives such as an easily administered blanket exemption if possible for the small businesses which the IRS never intended to have capitalize their costs.

If, upon analysis, the IRS believes that the proposed rule might require some reporting but ultimately will not have a significant economic impact on a substantial number of small businesses, the Commissioner is required to so certify in a new notice of proposed rule-making and support the finding with factual information.(10)

Thank you for this opportunity to comment. If the Office of Advocacy can be of assistance to you with regard to these comments or the hearing, please feel free to contact us at 202-205-6533.

Sincerely,

Jere W. Glover
Chief Counsel

Russell Orban
Assistant Chief Counsel

ENDNOTES

1. 5 U.S.C.A. 601 et seq.

2. 26 U.S.C. 7805(f)

3. 5 U.S.C. 601 et seq.

4. P.L.104-121

5. 15 U.S.C. 634( c )

6. 5 U.S.C. 601 (2)

7. 5 U.S.C. 601(7) and (8)

8. Congressional Record, April 19, 1996 p. E574

9. Federal Register Vol. 62, No. 163, August 22, 1997 p. 44543

10.PL 104-121, sec. 243 amending 5 U.S.C. 605(b)