under prior law. 5a In addition, certain costs incurred in producing poultry may be subject to capitalization and amortization under special rules. The limitations apply only to the extent prepayments for supplies (or poultry expenses) exceed 50 percent of the taxpayer's total deductible farming expenses. This excess amount may not be deducted any earlier than the taxable year of actual use or consumption of the supplies to which it relates.

For purposes of the 50-percent test, deductible farm expenses include the operating expenses of the farm, such as ordinary and necessary expenses within the meaning of section 162, interest and taxes paid, depreciation allowances on farm equipment, and other similar expenses. However, payments for feed, seed, fertilizer, or other supplies are deductible farm expenses only to the extent they are not prepayments, i.e., the supplies are consumed in the year of payment.

The Act provides two exceptions to the provision. First, the provision does not apply to an eligible farmer-a "farm-related taxpayer"-who fails to satisfy the 50-percent test due to a change in business operations directly attributable to extraordinary circumstances, including government crop diversion programs and circumstances described in Code section 464(d) (supplies on hand at the end of the taxable year due to fire, storm, or other casualty, disease, or drought). Second, the provision does not apply to farm-related taxpayers whose prepaid supplies do not exceed the 50-percent threshold applied by aggregating prepayments and expenses (other than prepayments) for the three preceding taxable years.

A farm-related taxpayer includes (1) any person whose principal residence is on a farm, (2) any person with a principal occupation of farming, and (3) any family member of persons described in (1) or (2). The exceptions apply only to farming activities attributable to the farm on which the residence is located, or to farms included in the "principal occupation" of farming activities.

Congress did not intend that farmers will be required generally to take year-end inventories of prepaid items as a result of this provisions of the Act.

In adopting these limitations, Congress did not intend to modify or supersede the general rule that prepaid expenses are not deductible if that deduction would result in a material distortion of income.

Effective Date

The provision applies to amounts paid or incurred after March 1, 1986, in taxable years beginning after that date.

5 Under the Act, farming syndicates (as defined under secs. 464 of prior law) are now re quired to use the accrual method of accounting. (See, new sec. 448.)

6 Generally these are the expenses reported on Schedule F of the taxpayer's Federal income tax return. Farm expenses do not include costs that must be inventoried or capitalized, e.g., the purchase price of an animal purchased for subsequent resale.

7 Prepaid expenses of taxpayers eligible for one of these exceptions may be deducted to the same extent as under prior law, without regard to the 50-percent limitation.

1

Revenue Effect

This provision is estimated to increase fiscal year budget receipts by $14 million in 1987, $30 million in 1988, $10 million in 1989, $11 million in 1990, and $14 million in 1991.

4. Discharge of indebtedness income for certain farmers (sec. 405 of the Act and secs. 108 and 1017 of the Code)8

Prior Law

Under prior and present law, gross income is defined to include income from discharge of indebtedness (sec. 61). If a solvent taxpayer received income from discharge of trade or business indebtedness, prior law provided the taxpayer an election to exclude that income if the taxpayer's basis in depreciable property was reduced (secs. 108 and 1017). If the amount of the discharge of indebtedness income exceeded a solvent taxpayer's available basis, the taxpayer recognized income in an amount of the excess.

Under prior (and present) law, if an insolvent taxpayer receives income from discharge of indebtedness, the income is excluded (to the extent it does not exceed the amount of the taxpayer's insolvency). The taxpayer's tax attributes must be reduced by the amount of the excluded income. Reduction is required in the following attributes (in the following order): net operating losses and carryovers, general business credit carryovers, capital loss carryovers, basis of property, 10 and foreign tax credit carryovers. An insolvent taxpayer may elect to reduce basis in depreciable property before reducing net operating losses or other attributes.

If the amount of the insolvent taxpayer's discharge of indebtedness income (not in excess of the amount of its insolvency) exceeds its available tax attributes, the excess is disregarded, i.e., is not includible in income.

Reasons for Change

Congress was aware of enacted and pending legislation intended to alleviate the credit crisis in the farming sector, and of potential tax problems that might undermine the effectiveness of this legislation. For example, programs providing Federal guarantees on limited amounts of farm indebtedness in exchange for a lender's agreement to reduce the total amount of a farmer's indebtedness when that farmer had a high debt-to-equity ratio (but was not insolvent) were under consideration. Congress was concerned that such farmers would recognize large amounts of discharge of indebtedness income as a result of these loan write-downs-forcing them to forfeit their farmland rather than participate in programs designed to enable them to continue in farming.

For legislative background of the provision, see: H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 706; S.Rep. 99-313, pp. 271-272; Senate floor amendment, 132 Cong. Rec. S7827 (June 18, 1986); and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 115-116 (Conference Report).

The amount of a taxpayer's insolvency is the excess of its liabilities over the fair market value of its assets.

10 The reduction in basis is limited to the excess of the aggregate bases of the taxpayer's property over the taxpayer's aggregate liabilities immediately after the discharge.

Explanation of Provision

Under the Act, certain solvent taxpayers realizing income from the discharge of certain farming-related indebtedness may reduce tax attributes, including basis in property, under rules similar to those applicable to insolvent taxpayers. The discharged indebtedness must have been incurred directly in connection with the operation of a farming business by a taxpayer who satisfies a gross receipts test.11 The gross receipts test is satisfied if the taxpayer's aggregate gross receipts from farming for the three years preceding the year of the discharge are 50 percent or more of his aggregate gross receipts from all sources for the same period. 12

If a taxpayer elects to exclude income under this provision, the excluded amount must be applied to reduce tax attributes of the taxpayer in the following order: (1) net operating losses, (2) general business credits, (3) capital loss carryovers, (4) foreign tax credit carryovers, (5) basis in property other than land used or held for use in the trade or business of farming, and (6) basis in land used or held for use in the trade or business of farming.

The amount of the exclusion under this provision may not exceed the aggregate amount of the tax attributes of the taxpayer specified above. Accordingly, income must be recognized to the extent the amount of the discharged indebtedness exceeds his available attributes. 13

Effective Date

The provision applies to discharge of indebtedness income realized after the April 9, 1986, in taxable years ending after that date.

Revenue Effect

This provision is estimated to decrease fiscal year budget receipts by $9 million in 1987, $10 million in 1988, $8 million in 1989, $7 million in 1990, and $5 million in 1991.

11 As under prior law, discharges of nonrecourse "loans" made by the Commodity Credit Corporation in connection with governmental crop price support programs, or other similar transactions that in substance constitute a sale of a farm product, are not within the scope of section 108 and hence are ineligible for relief under this provision.

12 A technical amendment may be necessary to clarify that this was the intended operation of the gross receipts test.

13 A technical amendment may be necessary to conform the Congress' intent that the relief for solvent farmers be as described above.

B. Oil, Gas, Geothermal, and Hard Mineral Properties

1. Intangible drilling costs and mining exploration and development costs (sec. 411 of the Act and secs. 263, 291, 616, and 617 of the Code)14

Prior Law

Intangible drilling and development costs

General rules

Under prior and present law, intangible drilling and development costs ("IDCs") may either be deducted in the year paid or incurred ("expensed") or else may be capitalized and recovered through depletion or depreciation deductions (as appropriate), at the election of the operator. In general, IDCs include expenditures by the operator incident to and necessary for the drilling and the preparation of wells for the production of oil or gas (or geothermal energy), which are neither for the purchase of tangible property nor part of the acquisition price of an interest in the property. IDCs include amounts paid for labor, fuel, repairs, hauling, supplies, etc., to clear and drain the well site, construct an access road, and do such survey and geological work as is necessary to prepare for actual drilling. Other IDCs are paid or incurred by the property operator for the labor, etc., necessary to construct derricks, tanks, pipelines, and other physical structures necessary to drill the wells and prepare them for production. Finally, IDCs may be paid or accrued to drill, shoot, fracture, and clean the wells. IDCs also include amounts paid or accrued by the property operator for drilling or development work done by contractors under any form of contract. 15

Only persons holding an operating interest in a property are entitled to deduct IDCs. This includes an operating or working interest in any tract or parcel of oil, gas, or geothermal property, either as a fee owner, or under a lease or any other form of contract granting working or operating rights. In general, the operating interest in an oil or gas property must bear the cost of developing and operating the property. The term operating interest does not include royalty interests or similar interests such as production payment rights or net profits interests.

If IDCs are capitalized, a separate election may be made to deduct currently IDCs paid or incurred with respect to nonproduc

14 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, secs. 251 and 262; H. Rep. 99-426, pp. 200-204, 213-215; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, secs. 715716; S. Rep. 99-313, pp. 280-282; and H. Rep. 99-841, Vol. II (September 18, 1986), pp. 120-125 (Conference Report).

15 See, Treas. Reg. sec. 1.612-4 (pertaining to oil and gas wells) and sec. 1.612-5 (pertaining to geothermal wells).

tive wells ("dry holes"), in the taxable year in which the dry hole is completed. Thus, a taxpayer has the option of capitalizing IDCs for productive wells while expensing those relating to dry holes.

Treatment of foreign IDCs

Domestic and foreign IDCs generally were subject to the same tax rules under prior law.

Twenty-percent reduction for integrated producers

In the case of a corporation which is an "integrated oil company",16 the allowable deduction with respect to IDCs that the taxpayer has elected to expense was reduced by 20 percent. The disallowed amount was required to be amortized over a 36-month period, starting with the month in which the costs were paid or incurred. Amounts paid or incurred with respect to non-productive wells (dry hole costs) remain fully deductible when the non-productive well is completed, under prior and present law.

Mining exploration and development costs

General rules

Under prior and present law, taxpayers may elect to expense exploration costs associated with hard mineral deposits (sec. 617). Taxpayers also may expense development costs associated with the preparation of a mine for production (sec. 616).

Mining exploration costs are expenditures for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other depletable mineral, which are paid or incurred by the taxpayer prior to the development of the mine or deposit. When the mine reaches the producing stage, adjusted exploration expenditures (but not development costs) either: (1) are included in income (i.e., recaptured) and recovered through cost depletion; or (2) at the election of the taxpayer, reduce depletion deductions with respect to the property. Adjusted exploration expenditures with respect to a property are expensed exploration costs attributable to the property, reduced by the excess of (a) percentage depletion which would have been allowed but for the deduction for expensed exploration costs, 17 over (b) cost depletion for the corresponding period. Exploration costs also are subject to recapture if the property is disposed of by a taxpayer after expensing these amounts (secs. 617(d)).

Development costs include expenses incurred for the development of a property after the existence of ores or other minerals in commercially marketable quantities has been determined. These costs typically include costs for construction of shafts and tunnels and, in some cases, costs for drilling and testing to obtain additional information for mining operations.

16 An integrated oil company, for purposes of this provision, is any producer that is not an independent producer (as defined for the purposes of percentage depletion (sec. 613A) and the crude oil windfall profit tax).

17 Because percentage depletion deductions are limited to 50 percent of net income from the property, deductions which reduce net income (e.g., the deduction for expensed exploration costs) may reduce the value of percentage depletion to the taxpayer.