Wednesday, January 31, 2018
Some taxpayers strive to convert a hobby or minor occupation into a more typical business operation. Doing so doesn’t present any problems with the IRS if the business makes money and, of course, all taxes are properly paid. But, what if the business activity loses money? If the losses stack-up over a length of time (deductions from the activity exceed income), the IRS may take the position that the activity is a hobby that is not engaged in with a profit intent as would be a legitimate business.
What is the consequence of being classified by the IRS as a hobby? Deductions that are attributable to an activity that is not engaged in for profit are significantly limited. I.R.C. §183(a). Certain deductions will remain available because they aren’t tied to whether the activity is a hobby or not. Those include state and local property taxes, home mortgage interest and casualty losses, for example. See Treas. Reg. §1.183-1(d)(2). But, deductions associated with conducting the activity will be limited to the excess of gross income from the activity over those expenses that are deductible regardless of whether the activity is entered into for profit. In addition, for hobby activities, allowed expenses are deducted on Schedule A (Form 1040) as a miscellaneous itemized deduction subject to the 2 percent-of-AGI (adjusted gross income) floor. This is the rule through 2017. For tax years beginning after 2017, there are no deductions against the hobby income due to the elimination of the 2 percent-of-AGI floor. If the activity isn’t a hobby, deductible expenses are business expenses that are deductible (even if they exceed income) on Schedule C. If the activity is a hobby, however, the income is reported as "other income" and is not subject to self-employment tax. But, the critical point is that if an activity is not engaged in for profit, then losses from the activity can’t be used to offset other income.
Note: Where property is used in several activities, and one or more of the activities is determined not to be engaged in for profit, deductions relating to the property must be allocated between the various activities on a reasonable and consistently applied basis. Treas. Reg. §1.183-1(d)(2).
In recent months, indications are that the IRS is pushing the hobby loss rules harder, particularly with respect to farming operations. In early 2017, I wrote about a pilot program that IRS was initiating involving Schedule F expenses for small business/self-employed taxpayer examinations. The program started on April 1, 2017 and will go through March of 2018. The focus will be on “hobby” farmers, and it could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F.
The hobby loss rules and farming/ranching operations, that’s the topic of today’s post.
The Hobby Loss Rules
The key question is where the line is drawn between a hobby and a business. In general, as noted above, a “hobby” is any activity that is not engaged in primarily for profit. If a taxpayer’s gross income from an activity exceeds deductions for three or more of the last five years, a presumption arises that the activity is not a hobby. In other words, an activity is presumed to be a business if there are profits for three or more of the last five years. For activities consisting of breeding, training, showing or racing horses, however, the presumption arises if there is a profit in any two out of the last seven years. The IRS can rebut the presumption by carrying the burden of proof and establishing a lack of profit motive. Thus, for farms or ranches operated for pleasure or recreation and not as commercial enterprises, the deduction of expenses is permitted if a profit occurs over a long enough period.
If the presumption does not resolve the issue of whether a farm is being operated for pleasure or recreation and not as a commercial enterprise, a determination must be made as to whether the taxpayer was conducting the activity with the primary purpose and intention of realizing a profit. The expectation of profit need not be reasonable, but there must be an actual and honest profit objective. Whether the requisite intention to make a profit is present is determined by the facts and circumstances of each case with the burden of proof on the taxpayer attempting to deduct the losses. See, e.g., Ryberg v. Comr., T.C. Sum. Op. 2012-24.
Nine-Factor Test of the Regulations
The hobby loss rules won't apply if the facts and circumstances demonstrate that the taxpayer has a profit-making objective. The IRS has developed nine factors) that are to be examined in determining whether the requisite profit motive exists. See, e.g., Treas. Reg. §1.183-2(b).
Business-like manner. The first IRS factor is concerned with the manner in which the activity is conducted. Is the activity being conducted in a manner that demonstrates that the taxpayer had a business purpose in mind, or is the taxpayer really conducting the activity as would be expected of someone engaged in a hobby? For instance, does the taxpayer keep adequate records and use them in a manner that is designed to aid the profitability of the business? See, e.g., Knudsen v. Comm’r, T.C. Memo. 2007–340. If the activity is conducted in a “business-like” manner, with accurate and complete records and books of account, the hiring of experienced supervisors or managers, or the seeking of expert advice, this factor will weigh in the taxpayer’s favor.
Expertise. The second factor focuses on the taxpayer’s expertise. If the taxpayer or an advisor has expertise in the particular agricultural area involved, a profit intent is shown. If, for example, the taxpayer has a small beef herd, does the taxpayer know anything about beef breeding or nutrition? What about health problems, etc.?
Time commitment. The third factor involves an examination of how much time the taxpayer devotes to the activity. Sufficient manual labor by the taxpayer may overcome an IRS argument that the taxpayer was engaged in a hobby operation. The question often boils down to whether the taxpayer put in enough time into the activity to reduce or eliminate successive years’ worth of losses.
Expectation of asset appreciation. The fourth factor recognizes that a realistic expectation of asset appreciation can show an intent to profit overall from the activity. See, e.g., Stromatt v. Comm’r, T.C. Sum. Op. 2011-42
Experience. The sixth factor looks at whether the taxpayer has been involved in a loss venture in the past that was turned around into a profitable venture. With respect to this factor, it is appropriate to examine the history of income on all sides of the activity.
History of income or loss. The sixth factor involves an examination of the history of income or loss from the activity. While start-up losses are to be expected in many ventures, continuing losses beyond the period usually required to achieve profitability may indicate a lack of a profit motive. There must be a prospect, not only for earning future profits, but for profits sufficient to offset losses sustained during the early years of operation. A taxpayer's subjective intent must be demonstrated with objective facts, such as comparing the taxpayer's income and loss numbers to comparable neighboring operations.
Amount of profit. The seventh factor examines the amount of profits earned from the activity. Activities generating large losses that occasionally produce a profit are not necessarily indicative of a profit intent. Also important are whether the only gross receipts are federal farm program payments.
Financial status. If the taxpayer has sufficient non-farm income to maintain a comfortable standard of living even with the losses from the “farming” activity, the factor will weigh in the favor of the IRS.
Elements of recreation and/or pleasure. If a taxpayer derives pleasure or recreational benefits from the activity, this factor will cut in favor of the IRS.
Two recent cases illustrate the application of the hobby loss rules to agricultural activities.
Large losses don’t necessarily negate profit intent. In Welch, et al. v. Comr., T.C. Memo. 2017-229, the taxpayer was a professor that taught at several universities over a 40-year span. In the 1970s he founded a consulting business. In the early 1980s he formed another business that provided software to researchers, and developed a statistical program in 2007 to assist businesses in their hiring practices. In 1987, he purchased an initial 130-acre tract with the original intent to grow hay as a cash crop and to raise some cattle.
Over time, the ranch grew to become a multi-operational, 8,700-acre ranch with 25 full-time employees. The ranch also had a vet clinic that provided services for large and small animals. In addition, the ranch had a trucking operation and owned numerous 18-wheel trucks that were used to move cattle and hay around the ranch and to transport cattle to and from market and perform backhauls. The ranch also conducted timber operations and employed a timber manager.
The taxpayer subscribed to numerous professional publications, and changed the type of cattle that the ranch raised to increase profitability. Steadily increasing herd size. The hay operation was also modified to maximize profitability due to weather issues. In addition, the ranch built its own feed mill that was used to chopping and dry storage of the hay. In 2003, the taxpayer also started construction of a horse center as part of the ranch headquarters, including a breeding facility that operated in tandem with the veterinary clinic. Ultimately, the taxpayer’s horses were entered in cutting competitions, with winnings increasing annually from 2007 to 2010.
The IRS issued notices of deficiency for 2007-2010. For those years, the taxpayer had total losses of approximately $15 million and gross income of approximately $7 million. Also, for those years, the taxpayer’s primary expense was depreciation. The IRS claimed that the ranching activity was not engaged in for profit and the expenses were deductible only to the extent of income.
The Tax Court determined that all of the taxpayer’s activities were economically intertwined into a single ranching activity. On the profit issue, the court determined that none of the factors in the Treasury Regulations favored the IRS. Accordingly, the taxpayer’s ranching activity was held to be conducted for-profit and the losses were fully deductible. The court specifically rejected the IRS argument that a profit motive could not be present when millions of dollars of losses were generated.
Reasonable jury could find profit intent. In Wicks v. United States, No. 16-CV-0638-CVE-FHM, 2018 U.S. Dist. LEXIS 9352 (N.D. Okla. Jan. 22, 2018), the plaintiff owned and operated a company that provided mechanical inspection services for major oil refineries and gas plants. That business was quite profitable. In addition to his business, the plaintiff, in the late 1990’s, started in the cattle business when he bought 80 acres of land containing a dilapidated barn and unusable fence. He repaired the fence and barn and purchased two longhorn heifers, built a new barn, bought and adjacent 180-acre tract so he could increase the herd to make the venture ultimately profitable, and improved the entire property by replacing fence, enlarging an existing pond, installing rural water and constructing a cattle working facility and loafing shed. The plaintiff also consulted with a successful local rancher regarding profitable methods of cattle ranching. He also purchased 20 cows to crossbreed so as to produce quality milk and beef, knowing that obtaining a crossbreed would take at least four years. The plaintiff also purchased new hay baling equipment and feed bins.
The plaintiff performed all of the labor and spent three to four days weekly working on the ranching activity. However, the cattle ranching activity never showed a year of profitability, with total gross receipts from 1997 through 2015 totaling $32,602 and net losses totaling $807,380. The plaintiff did not establish a written business plan or have any written financial projections, and did not use any accounting software or form a business entity for the cattle operation, although he did use a spreadsheet to track his expenses. He also did not market or promote the cattle operation, insure the herd against catastrophic loss or consult a financial advisor. Before 1997, the plaintiff’s only experience with cattle was feeding and working them as a child. He sold cattle in 2013, after the cattle market had rebounded from prior lows, and also attended seminars on cattle breeding and pasture management and read as much as he could about raising cattle. He also joined two different state cattlemen’s associations.
For 2010 and 2011, the IRS denied the loss deductions from the plaintiff’s cattle ranching activity, and assessed penalties with the total amount of tax and penalties (including interest) due being $89,838.09. The plaintiff paid the deficiency (plus interest) and sued for a refund, claiming that he engaged in the cattle ranching activity with profit intent). The IRS moved for summary judgment, arguing that the activity was not engaged in for profit and the resulting losses were non-deductible under the hobby loss rules of I.R.C. §183. On an evidentiary question, the court allowed tax return information from post-2011 years into evidence because it was relevant in showing whether the plaintiff had a profit intent for the tax years in issue. The court also allowed into evidence testimony of an ag economist for the plaintiff to the extent the testimony bore on economic conditions and their impact on the plaintiff’s cattle ranching activity.
The court examined each of the nine factors in the regulations and ultimately determined that, based on the totality of the circumstances, and viewing the evidence in the light most favorable to the plaintiff, a reasonable jury could conclude that the plaintiff engaged in the cattle ranching activity with a profit intent. The court denied the IRS motion for summary judgment.
The IRS is looking closely at agricultural activities that it believes might be a hobby. Operating the activity in conformity with the regulations is a must for maintaining full deductibility of expenses associated with the activity.