Facts: Mrs. McDonald is our client. She was married to Mr. McDonald for forty years. On January 15, Year 2, Mr. McDonald died. Mrs. McDonald was his sole heir and she inherited all of his property. The McDonalds are/were U.S. citizens who are/were cash method, calendar year taxpayers. The McDonalds reported their farm income using the cash method, not the crop or any other method. For all years of their marriage (including Year 2), the McDonalds filed joint Federal Income tax returns. Beginning in Year 3, Mrs. McDonald will be filing as a single taxpayer.

Mr. McDonald owned the Old McDonald farm which was classified as a sole proprietorship for Federal Income tax purposes. For decades, he grew various crops and sold the harvest. In Year 1, Mr. McDonald purchased farm inputs[1] to use in operating the farm. The cost of these inputs was $50,000. As he had done for many years, Mr. McDonald fully deducted the cost of the inputs under Code section 162 on the Schedule F of the McDonalds Year 1 Federal Income tax return. The inputs were not used by the farm in Year 1.

When Mr. McDonald died on January 15, Year 2, Mrs. McDonald inherited all his property, including the farm inputs. Under Code section 1014, Mrs. McDonalds basis in the inputs was $50,000.[2] Mrs. McDonald took all the farm assets she inherited, including the inputs, and created a new sole proprietorship (the New McDonald farm) and became a farmer herself. In Year 2, Mrs. McDonald deducted the $50,000 cost of inputs under Code section 162 . The inputs were used by the farm in Year 2. However, the crops that grew related to them were not harvested and sold until Year 3.

Issues:

1) Was the deduction of the inputs in Year 1 proper?

2) Was the deduction of the inputs in Year 2 proper?

3) If the deductions were properly taken in Years 1 and 2, should the tax benefit rule apply to cause income recognition Year 2?

[1] Seeds, fertilizer, chemicals, and fuel.

[2] Code section 1014 provides that those who inherit property from a decedent take fair market value basis in the property. The inputs, which were purchased for $50,000, did not appreciate or depreciate during the time that Mr. McDonald held them. Their fair value on the date of death was $50,000.