Comm'r of Internal Revenue

United States Tax CourtApr 17, 1972
58 T.C. 81 (U.S.T.C. 1972)
58 T.C. 81T.C.

Docket Nos. 4756-68 4757-68.



Harvey R. Friedman and Sidney J. Machtinger, for the petitioners. Earl Goldhammer and Stephen W. Simpson, for the respondent.

Harvey R. Friedman and Sidney J. Machtinger, for the petitioners. Earl Goldhammer and Stephen W. Simpson, for the respondent.

H & G made payments to R.R. which they allege represented the purchase price of calves and the costs of raising them to maturity. They claim deductions under sec. 1.162-12, Income Tax Regs., for the amounts alleged to constitute raising costs and under sec. 167(a), I.R.C. 1954, for depreciation of the costs of the animals. Held, the transaction was not a sham; on this holding, respondent concedes that H & G are entitled to deductions for depreciation. Held, further, under the terms of their agreement with R.R., H & G acquired mature milch cows and, therefore, are not entitled to deduct the raising costs under sec. 1.162-12, Income Tax Regs.


Respondent determined deficiencies in petitioners' Federal income taxes for 1964 and 1965 as follows:

+-------------------------------------------------------+ ¦Petitioners ¦1964 ¦1965 ¦ +---------------------------------------+-------+-------¦ ¦ ¦ ¦ ¦ +---------------------------------------+-------+-------¦ ¦Herbert D. Wiener and Shirley M. Wiener¦$40,824¦$19,853¦ +---------------------------------------+-------+-------¦ ¦George M. Wiener and Barbara E. Wiener ¦42,736 ¦13,070 ¦ +-------------------------------------------------------+

Some issues having been stipulated, the sole remaining issue is whether certain outlays of funds by petitioners during 1964 and 1965 constituted costs of raising calves for subsequent inclusion in a dairy herd within the meaning of section 1.162-12, Income Tax Regs.


Herbert D. Wiener (hereinafter referred to as Herbert) and Shirley M. Wiener, husband and wife, and George M. Wiener (hereinafter George) and Barbara E. Wiener, husband and wife, were legal residents of Encino, Calif., at the time they filed their petitions. Both couples filed their respective joint Federal income tax returns for 1964 and 1965 with the district director of internal revenue, Los Angeles, Calif.

Herbert and George (sometimes hereinafter petitioners) are brothers; they have been engaged in the practice of law in California since 1947 and 1944, respectively. In 1949, they, together with George K. Bramet (hereinafter Bramet), a childhood friend of George, purchased some cows for the purpose of developing a beef cattle herd. For a fee, these cattle were cared for at the Los Flores Ranch, owned by Edward C. Chilcott (hereinafter Chilcott), Bramet's employer. Chilcott is also one of George's clients. The herd was sold at a profit in 1953.

From the time they sold their cattle herd until 1963, petitioners neither owned cattle nor had any other financial interest in the cattle business. However, during this period, George became aware of the financial opportunities offered by the dairy business. In 1963, when Herbert and George were about to realize an unusually large amount of income from a business venture, they began to negotiate with Bramet and Chilcott on the possibility of acquiring a dairy herd. At that time, Chilcott owned the River Ranch Co. (hereinafter River Ranch or the Ranch) which was engaged in extensive dairy operations in California, Oregon, and Arizona. One of River Ranch's activities involved the raising of Holstein calves to a milking stage, either to be used in its own dairy operations or to be sold to other dairymen for use in their herds. Bramet was controller of River Ranch.

The transaction as contemplated at that time was that Herbert and George jointly would pay $330 per calf to River Ranch. For that sum, River Ranch would purchase a heifer calf and maintain her for approximately 28 months until she had borne a calf and was ready for dairy use. If the calf were to die or be culled for any reason prior to entering the milking stream of a dairy, the Ranch would either substitute another cow or repay Herbert and George $330. Petitioners did not have a license to ship or market milk, but it was contemplated that River Ranch would lease the mature cows or use its best efforts to lease them to a reliable dairy.

Herbert and George were told that when a cow was placed with a dairy, they could expect to receive $72 per year for her milk production (less a 20-percent commission paid to River Ranch for its services) and an average of about $17.50 per year from the sale of her calves ($28 for a heifer and $7 for a bull calf). Each milch cow was expected to have a calf each year and to produce milk as part of a dairy herd for about 305 days per year. After the cow had reached the age when she was no longer able to produce milk economically—usually about 3 years— she would be sold at an estimated price of $200. During these discussions, Herbert, George, and Bramet also considered the tax advantages that the transaction would present.

On August 12, 1963, petitioners entered into an ‘Agreement to Raise Dairy Herd’ with River Ranch, as follows (references to Wiener therein being to Herbert, George, and their wives):

1. That River Ranch will purchase, pick up and raise Holstein heifer calves for and on behalf of Wiener. The cost of purchasing such calves will in most instances be somewhat in excess of the established market price for such animals in order that River Ranch may select calves of superior quality from the higher producing dairies. It is the intent of River Ranch that were possible such calves will be selected from artificially inseminated dams, although River Ranch shall exercise its own judgment and discretion in this regard.

2. River Ranch will charge Wiener the sum of Three Hundred Thirty Dollars ($330.00) to completely care for each calf, such charge to include but not be limited to all labor, feed, breeding, veterinary care, supervision and overhead charges including death and sterility costs, until said calf shall mature to the age of approximately twenty-eight (28) months. In the event that there shall be a major change in such costs a mutually agreed adjustment reasonably commensurate to such change will be negotiated in said raising price.

3. River Ranch will make every effort to breed each heifer in order that the freshening date will approximate twenty-eight (28) months of age for each of said heifers.

4. Approximately sixty (60) days before the calving date for each animal, River Ranch will diligently undertake to enter into the necessary arrangements to have said animal milked for Wiener and will execute milking contracts for and on behalf of Wiener; that a copy of such proposed milking contracts which the parties approve is attached hereto, marked Exhibit ‘A’ incorporated herein, and by this reference made a part hereof as though herein set forth at length.

(a) River Ranch will charge Wiener Twenty Percent (20%) of the milking income as and for costs of supervision, breeding, collection, overhead, etc., and will remit the balance to Wiener. Each remittance advice will show: (a) Lease number and (b) period covered by remittance.

(b) In the event an animal is returned by the dairy, River Ranch will in its sole and exclusive discretion elect to enter into a contract with another dairy under the terms and conditions of Exhibit ‘A’ or sell such animal. River Ranch will notify Wiener of its determination and promptly deliver a copy of the new milking contract or the proceeds of the sale.

(c) In the event of the death of an animal River Ranch will whenever possible obtain a ‘Death Certificate’ and forward a copy thereof to Wiener, or alternatively, will notify Wiener of the death and the identification number of the deceased animal.

(d) In the event River Ranch is not successful in obtaining a dairy to execute a milking contract per Exhibit ‘A’ and to discharge its responsibilities pursuant to the terms and provisions thereof for any one or several animals, then said animals shall be sold by River Ranch and the proceeds of such sale promptly forwarded to Wiener.

5. Until an animal has become subject to a ‘Milking Agreement’ River Ranch may co-mingle Wiener's animals with its own as well as animals belonging to others; to insure uniform treatment the identity of Wiener's animals will not be disclosed to ranch employees.

6. It is the intent of the parties to the within agreement that this agreement is being entered into for an indefinite period and it is contemplated that it shall continue for a period of many years; the parties hereto declare that if each had not had the assurances of the other as to this long range intention that the within arrangement would not have been undertaken; nevertheless, it is understood and agreed that should it become necessary for either party to withdraw from the within agreement either may do so upon giving thirty (30) day written notice of termination to the other. In the event that such notice of termination shall be served upon River Ranch by Wiener, River Ranch shall have a lien upon and the right to retain so many of Wiener's animals as shall be reasonably required to secure any unpaid liability which Wiener may have to River Ranch; and, at the sole election of River Ranch, such animals may be sold and the proceeds utilized to discharge any such liability. In the event that such notice of termination shall be served upon Wiener by River Ranch then, at the exclusive option of Wiener, River Ranch shall be obligated to raise all calves started to sixty (60) days before freshening, and, additionally, at the option of Wiener be further obligated to sell such animals for Wiener.

7. It is further expressly understood and agreed by and between the parties hereto that the covenants and agreements hereof shall apply to and bind the heirs, executors, administrators, and assigns of the respective parties hereto, and it is further expressly agreed that said dairy herd shall not be encumbered in whole or in part except with the written consent of River Ranch.

Attached to the above agreement as exhibit ‘A’ was a signed ‘Milking Service Agreement,‘ also dated August 12, 1963. Under the terms of this agreement, petitioners were obligated to deliver to River Ranch 26 dairy cows per month, starting in December 1965, until the total had reached 303 cows. These cows were to be delivered either to River Ranch at Mira Loma, Calif., or to Dewer Dairy, owned and controlled by River Ranch, at Mesa, Ariz. River Ranch was to pay all the costs of feeding and maintaining the cows and $72 per year for the use of such cows.

In view of petitioners' concern about the possibility of losing their investment through death, disease, or other catastrophe affecting their herd, this written agreement was modified by an oral one. To protect them against such risks of loss, River Ranch agreed to refund the $330 paid in by petitioners for each animal in the event that River Ranch failed to deliver a mature cow and rent her to a reliable dairy.

These agreements did not cause any significant change in the operation of River Ranch. Its calf buyer continued to make daily rounds of the dairies in the Chino Valley area, purchasing the calves to be raised at the Ranch. The bills of sale received by the calf buyer continued to show River Ranch as the purchaser. The buyer issued a numbered check for each calf he bought and placed a tag bearing the same number in the ear of the calf. Records bearing these check numbers were then set up in the Ranch office for each calf. These records, which were kept on cards as well as on a computer tape, reflected for each calf its number, sire, dam, owner, breed, birth date, purchase date, seller, and purchase price.

When the calves were between 3 and 6 months old, they were all branded with the River Ranch brand, and then at the age of about 6 months, they were all shipped to a ranch in Idaho, owned by Winslow B. Whiteley (hereinafter Whiteley), where they were maintained for about 16 to 18 months.

River Ranch raised calves for a number of Dairies, in addition to its own, and each calf's owner was identified by a designated number. These assigned numbers used by River Ranch were the only records indicating that petitioners owned any interest in the calves.

Under the terms of an agreement between River Ranch and Whiteley, the latter was entitled to one-half of the calves raised by him. The agreement in effect prior to September 29, 1965, provided that the animals would be divided equally with ‘no choice to either * * * (Whiteley) or * * * (River Ranch) in making this division.’ A new agreement, which became effective on that date, was premised on there being an equal division of the proceeds from the sale of the animals, but further provided that

If there is any division of heifers made, there will be no choice as between * * * (Whiteley) and * * * (River Ranch) and the division will be made using alternate numbers in a numerical sequence covering the animals which are to be divided.

About 60 days before the heifers were ready to enter the dairy stream, they were returned to River Ranch at Mira Loma, Calif. When they bore their calves, they either were used to replace cows on the dairy stream or were sold to other dairies.

When petitioners indicated they wished to acquire a cow, River Ranch would make an entry in its records indicating that two calves were ‘owned’ by petitioners. This procedure was followed in recognition of River Ranch's agreement with Whiteley that he would own one-half of all the animals which he cared for in Idaho. Only the employees in River Ranch's recordkeeping office knew of the arrangement between River Ranch and petitioners. About 6 months after the entry was made, petitioners were billed for a $28 ‘purchase price’ and a $302 ‘raising cost’ for each animal that they ordered.

When the calves designated as owned by petitioners were brought back from Idaho, they were either sold or placed in a dairy. If they were sold, petitioners were refunded $330 per cow, regardless of the amount realized from the sale. If they entered a dairy, petitioners were informed for the first time of the particular cows which they owned. When the animals were sold, River Ranch was designated on the bill of sale as the seller.

During the period from August 12, 1963, until September 5, 1966, petitioners jointly, except as otherwise noted, were billed for the following amounts by River Ranch:

+---------------------------------------------------------------+ ¦Date ¦Number of cows¦Cost of calves¦Cost of raising¦ +-----------------+--------------+--------------+---------------¦ ¦ ¦ ¦ ¦ ¦ +-----------------+--------------+--------------+---------------¦ ¦Jan. 27, 1964 ¦303 ¦$8,484 ¦$36,828.16 ¦ +-----------------+--------------+--------------+---------------¦ ¦Mar. 24, 1964 ¦ ¦ ¦30,210.63 ¦ +-----------------+--------------+--------------+---------------¦ ¦June 4, 1964 ¦ ¦ ¦24,467.21 ¦ +-----------------+--------------+--------------+---------------¦ ¦Dec. 3, 1964 ¦86 ¦2,408 ¦26,204.00 ¦ +-----------------+--------------+--------------+---------------¦ ¦Dec. 16, 1964 ¦121 ¦3,388 ¦36,523.00 ¦ +-----------------+--------------+--------------+---------------¦ ¦Dec. 21, 1964 ¦91 ¦2,548 ¦27,434.15 ¦ +-----------------+--------------+--------------+---------------¦ ¦Dec. 24, 1964 ¦23 ¦644 ¦6,848.21 ¦ +-----------------+--------------+--------------+---------------¦ ¦Dec. 20, 1965 1 ¦121 ¦3,388 ¦36,542.00 ¦ +-----------------+--------------+--------------+---------------¦ ¦Dec. 20, 1965 2 ¦106 ¦2,968 ¦32,012.00 ¦ +-----------------+--------------+--------------+---------------¦ ¦Sept. 5, 1966 1 ¦75 ¦2,100 ¦22,650.00 ¦ +-----------------+--------------+--------------+---------------¦ ¦Sept. 5, 1966 2 ¦91 ¦2,548 ¦27,482.00 ¦ +---------------------------------------------------------------+

1,017 28,476 3 307,201.36

Petitioners paid the amounts of such bills.

Shortly before the first cows were due to enter a dairy, River Ranch informed petitioners that it would be unable to pay the $72 fee provided in the ‘Milking Service Agreement’ and that it would likely be unable to place the animals in another dairy as provided by the ‘Agreement to Raise Dairy Herd.’ Petitioners then agreed to temporarily accept only $19.80 per year for each cow placed at Dewer Dairy. During this period, both George and River Ranch attempted to locate some other reliable dairy to milk the cows for a more profitable rental. They were unable to do so. Finally, during 1967, petitioners decided to liquidate their herd.

Cows designated in the River Ranch records as purchased for petitioners were either sent to Dewer Dairy under the modified rental agreement, or sold and the $330 payment for each animal refunded to petitioners as follows:

+--------------------------------+ ¦ ¦Sent to ¦Number sold ¦ +-------+---------+--------------¦ ¦ ¦Dewer ¦at River ¦ +-------+---------+--------------¦ ¦Date ¦Dairy ¦Ranch ¦ +-------+---------+--------------¦ ¦1965 ¦ ¦ ¦ +-------+---------+--------------¦ ¦ ¦ ¦ ¦ +-------+---------+--------------¦ ¦Dec. 18¦18 ¦ ¦ +-------+---------+--------------¦ ¦ ¦ ¦ ¦ +--------------------------------+

1966 Jan. 15 21 Jan. 22 25 Feb. 18 23 Mar. 19 24 15 Apr. 6 31 18 Apr. 19 26 May 6 26 15 June 3 20 13 July 6 22 13 July 14 31 Aug. 4 19 12 Sept. 2 10 Oct. 5 16 Oct. 12 30 Nov. 9 31 Dec. 14 31

1967 Jan. 11 13 13 Feb. 2 11 13 Mar. 3 13 April 13 May 16 21 9 June 24 July 15 August 22 September 27 October 26 November 21 December 26

1968 January 27 February 26 March 26 April 17 May 19 June 18 July 32 August 23 September 26 October 30 November 16 Total 449 568

After October 31, 1970, petitioners no longer owned any cows. By that date, they had sold all their cattle. The decision as to whether to remove a cow from the milking stream and sell her was left to the sole discretion of the employee of River Ranch who was responsible for the care and milking of the cows.

On their returns for 1964, 1965, and 1966, petitioners claimed the following deductions as cattle-raising costs:

+---------------------------+ ¦Year ¦Herbert ¦George ¦ +------+-----------+--------¦ ¦1964 ¦$94,258 ¦$94,258 ¦ +------+-----------+--------¦ ¦1965 ¦36,542 ¦32,012 ¦ +------+-----------+--------¦ ¦1966 ¦1 22,650 ¦27,482 ¦ +------+-----------+--------¦ ¦Total ¦153,450 ¦153,752 ¦ +------+-----------+--------¦ ¦ ¦ ¦ ¦ +---------------------------+

These amounts were billed to Herbert.

On their returns for 1966 through 1970, petitioners reported the following total amounts of income from this venture:

These amounts were billed to George.

The general rule is that costs incurred in the acquisition or development of capital assets and other property used in a trade or business are to be capitalized. Sec. 263(a). However, section 162(a) has been interpreted to allow current deductions for expenses paid in raising livestock. United States v. Catto, 384 U.S. 102, 106 (1966). In this connection, section 1.162-12, Income Tax Regs., contains the following:
The purchase of feed and other costs connected with raising livestock may be treated as expense deductions insofar as such costs represent actual outlay * * *. Amounts expended in purchasing work, breeding, or dairy animals are regarded as investments of capital, and shall be depreciated * * *
As was observed in Maple v. Commissioner, 440 F.2d 1055, 1056-1057 (C.A. 9, 1971), affirming a Memorandum Opinion of this Court:
If a dairy farmer buys his cows fully mature, he must capitalize their purchase price; if he buys them as calves, he may deduct the cost of raising them to maturity, even though that expense is as much a cost of obtaining an income-producing business as is the purchase of the mature cows. * * *
* * * Expenses of maintaining agricultural items in the preproductive state are deductible if they are sufficiently similar to the expenses that will be required to maintain them once they are productive. * * *

The $67.36 difference between this amount ($307,201.36) and the $307,134 anticipated expense ($302X1,017) has not been explained.

See also Mim. 6030, 1946-2 C.B. 45.

1Herbert actually claimed a deduction for $24,750, but he has conceded that this deduction was overstated by $2,100.

+------------------------------------------------------------+ ¦ ¦Herbert ¦George ¦ +-----------------------------------------+---------+--------¦ ¦Sale of milk and calves (ordinary income)¦$16,810 ¦$16,810 ¦ +-----------------------------------------+---------+--------¦ ¦Sale of cows (long-term capital gain) ¦136,498 ¦136,800 ¦ +-----------------------------------------+---------+--------¦ ¦Total ¦153,308 ¦153,610 ¦ +------------------------------------------------------------+

During 1966 through 1969, the following numbers of cows which had been sent to Dewer Dairy died:

+-------------------+ ¦Year ¦Number of ¦ +------+------------¦ ¦ ¦animals ¦ +------+------------¦ ¦1966 ¦3 ¦ +------+------------¦ ¦1967 ¦6 ¦ +------+------------¦ ¦1968 ¦11 ¦ +------+------------¦ ¦1969 ¦9 ¦ +------+------------¦ ¦Total ¦29 ¦ +-------------------+

Taking into account the total amounts invested by Herbert and George, the losses they suffered from the death of some cows while in dairy use, and the income which they received from the venture, Herbert and George each lost approximately $548 from the entire transaction.

Respondent determined that the deductions claimed for the cost of raising cows during 1964 and 1965 are not allowable because

it has not been established that any part of * * * (the amounts paid) to the River Ranch Company represented the payment of ordinary and necessary expenses attributable to a dairy herd operated by or for * * * (the petitioners).