Monday, July 16, 2018
In recent years, the IRS has shown an increased focus on business activities that it believes are being engaged in without an intent to make a profit. If that is the case, the “hobby loss” rules apply and limit deductions to the amount of income from the activity. But, engaging in an activity with a profit intent may not be enough to fully deduct losses from the activity. That’s particularly the case if the taxpayer hires a paid manager to run the operation. In that situation, the IRS may claim that the taxpayer is not materially participating in the activity under the passive loss rules. If the IRS prevails on that argument, loss deductions are severely limited, if not eliminated.
A recent Tax Court case involved both the hobby loss rules and the passive loss rules. While the ranching activity was deemed not to be a hobby, the court believed that the taxpayer was not materially participating in the activity.
Paid managers and the passive loss rules – that’s the focus of today’s post.
Passive Loss Rules
The passive loss rules, enacted in 1986, reduce the possibility of offsetting passive losses against active income. I.R.C. §469(a)(1). The rules apply to activities that involve the conduct of a trade or business (generally, any activity that is a trade or business for purposes of I.R.C. §162) where the taxpayer does not materially participate (under at least one of seven tests) in the activity on a basis which is regular, continuous and substantial. I.R.C. § 469(h)(1). Property held for rental usually is a passive activity, however, regardless of the extent of the owner's involvement in the management or operation of the property.
If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains). Losses (and credits) that a taxpayer cannot use because of the passive loss limitation rules are suspended and carry over indefinitely to be offset against future passive activity income from any source. I.R.C. §469(b). For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, as noted, the losses from the venture cannot be used to offset the income from the farming operation.
Facts. In Robison v. Comr., T.C. Memo. 2018-88, the petitioners were a married couple who lived in the San Francisco Bay area. The husband worked in the technology sector, and during the years in issue (2010-2014) the husband’s salary ranged from $1.4 million to $10.5 million. In 1999, the petitioners bought a 410-acre tract in a remote area of southeastern Utah for $2,000,000. They later acquired additional land, bringing their total land holdings to over 500 acres. The wife sold her physical therapy practice to focus her time on the administrative side of their new ranching activity.
The property was in shambles and the petitioners spent large sums on infrastructure to refurbish it. The began a horse activity on the property which they continued until 2010. The activity never made money, with a large part of the losses (roughly $500,000 each year) attributable to depreciation, repairs due to vandalism, and infrastructure expense such as the building of a woodshop and cement factory as the property’s remote location made repair work and build-out necessary to conduct on-site. The petitioners did not live on the ranch. Instead, they traveled to the ranch anywhere from four to ten times annually, staying approximately 10 days each time. The petitioners drafted all employee contracts, and managed all aspects of the horse activity.
They deducted their losses from the activity annually, and presumably because of the continued claimed losses, they were audited by the IRS in 2004 and 2008. Each of those audits concluded with an IRS determination that the petitioners were conducting a trade or business with profit intent (e.g., the activity was not a hobby). The IRS also determined that the petitioners were materially participating for purposes of the passive loss rules. The petitioners did not maintain contemporaneous records of their time spent on ranch activities. However, for each of those audits, the petitioners prepared time logs based on their calendars and their historical knowledge of how long it took them to complete various tasks. The IRS deemed the petitioners’ approach to documenting and substantiating their time spent on various ranch activities as acceptable. That documentation showed that the petitioners were putting over 2,000 hours (combined) into the ranch activity annually. In one year alone, they devoted more than 200 hours dealing with the IRS audit.
In 2010, the petitioners shifted the ranch business activity from horses to cattle. The husband retired in 2012 and, upon retirement, the couple moved to Park City, Utah, with the husband devoting full-time to the ranching activity along with his wife. The cattle operation was strictly grass-fed, with the cattle grazing upper-elevation Bureau of Land Management (BLM) land during the summer months. The petitioners negotiated the lease contracts with the BLM. They also hired a full-time ranch manager to manage the cattle. However, the petitioners managed the overall business of the ranch. From 2013-2015, the losses from the ranch declined each year.
The IRS initiated a third audit (all three audits involved different auditors) of the petitioners’ ranching activity, this time examining tax years 2010-2014. The IRS examined whether the activity constituted a hobby, but raised no questions during the audit concerning the petitioners’ material participation. The IRS hired an expert who spent three days at the ranch looking at all aspects of the ranching activity and examining each head of cattle. The expert produced a report simply concluding that the petitioners had too many expenses for the activity to be profitable. This time the IRS issued a statutory notice of deficiency (SNOD) denying deductions for losses associated with the ranching activity. The IRS claimed that the ranching activity was a “hobby,” and also raised the alternative argument that the petitioners failed to satisfy the material participation test of the passive loss rules.
The petitioners disagreed with the IRS’ assessment and filed a petition with the U.S. Tax Court. The IRS did not disclose to the petitioners whether the petitioners’ alleged lack of material participation was an issue until two days before trial. At the seven-hour trial, the court expressed no concern about any lack of profit motive on the petitioners’ part. The IRS’ trial brief focused solely on the hobby loss issue and did not address the material participation issue. In addition, the IRS did not raise the material participation issue at trial, and it was made clear to the court that the paid ranch manager was hired to manage the cattle, but that the overall business of the ranch was conducted by the petitioners. At the conclusion of the trial, the court requested that the parties file additional briefs on the material participation issue.
Tax Court’s opinion – hobby loss rules. Judge Cohen determined that the ranching activity was not a hobby based on the nine factors set forth in Treas. Reg. §1.183-2. One of the key factors in the petitioners’ favor was that they had hired a ranch manager and ranch hand to work the ranch and a veterinarian to assist with managing the effects of high altitude on cattle. This indicated that the activity was being conducted as a business with a profit intent. They had many consecutive years of losses, didn’t have a written business plan and didn’t maintain records in a manner that aided in making business decisions. However, the court noted that they had made a significant effort to reduce expenses and make informed decisions to enhance the ranch’s profitability. Indeed, after ten years of horse activity, the petitioners changed the ranching activity to cattle grazing in an attempt to improve profitability. While the petitioners’ high income from non-ranching sources weighed against them, overall the court determined that the ranching activity was conducted with the requisite profit intent to not be a hobby.
Note: While the court’s opinion stated that the horse activity was changed to cattle in 2000, the record before the court indicated that the petitioners didn’t make that switch until 2010.
Tax Court’s opinion – passive loss rules. However, Judge Cohen determined that the petitioners had failed to satisfy the material participation test of the passive loss rule. The losses were, therefore, passive and only deductible in accordance with those rules. The court determined that only two of the seven tests for material participation were relevant – the 500-hour test (Treas. Reg. § 1.469-5T(a)(1)) and the facts and circumstances test (Treas. Reg. §1.469-5T(a)(7)). As for the 500-hour test, the court took issue with the manner in which the petitioners documented their time spent on the ranching activity. The court opined that the logs were merely estimates of time spent on ranch activities and were created in preparation for trial. The court made no mention of the fact that the IRS, on two prior audits, raised no issue with the manner in which the petitioners tracked their time spent on ranch activities and had not questioned the accuracy of the logs that were prepared based on the petitioners’ calendars during the third audit which led to the SNOD and eventual trial.
As for the facts and circumstances test, the court determined that the petitioners could not satisfy the test because of the presence of the paid ranch manager. The court made no distinction between the cattle grazing activity which the ranch manager was responsible for and the overall business operations for which the petitioners were responsible. Indeed, on the material participation issue, due to the presence of the ranch manager, all of the personal actions and involvement of the petitioners on which the court based its determination of their profit motive were dismissed as “investor” hours.
The regulations do not list the facts and circumstances considered relevant in the application of the test, but the legislative history behind the provision does provide some guidance. Essentially, the question is whether and how regularly the taxpayer participates in the activity. Staff of Joint Comm. on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986, at 238 (Comm. Print 1987) [hereinafter 1986 Act Bluebook]. A taxpayer that doesn’t live at the site of the activity can still satisfy the test. Id. While management activities can qualify as material participation, they are likely to be viewed skeptically because of the difficulty in verifying them. See, e.g., HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986); 1986 Act Bluebook, supra note 35, at 240. Merely “formal and nominal participation in management, in the absence of a genuine exercise of independent discretion and judgment is not material participation.” HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986). Thus, the decisions the taxpayer makes must be important to the business (and they must be continuous and substantial).
It is true that a taxpayer’s management activities are ignored if any person receives compensation for management services performed for the activity during the taxable year. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Clearly, this exclusion applies where the “taxpayer has little or no knowledge or experience” in the business and “merely approves management decisions recommended by a paid advisor.” See Treas. Reg. §1.469-5T(k), Ex. 8. However, the regulation applies well beyond those situations. In addition, a taxpayer's management work is ignored if some other unpaid manager spends more time than the taxpayer on managing the activity. Treas. Reg. § 1.469-5T(b)(ii)(B). Thus, there is no attributions of the activities of employees and agents to the taxpayer for purposes of the passive loss rules, but hiring a paid manager does not destroy the taxpayer’s own record of involvement for the material participation purposes except for the facts and circumstances test. See, e.g., S. Rep. No. 313, 99th Cong., 2d Sess. 735 (1986)( “if the taxpayer’s own activities are sufficient, the fact that employees or contract services are utilized to perform daily functions in running the business does not prevent the taxpayer from qualifying as materially participating”).
Clearly, the petitioners’ type of involvement in the ranching activity was not that of an investor. However, equally clearly was that the petitioners’ method of recordkeeping was a big issue to the court (even though IRS was not concerned). The preparation of non-contemporaneous logs and those prepared from calendar entries has been a problem in other cases. See, e.g., Lee v. Comr., T.C. Memo. 2006-193; Fowler v. Comr., T.C. Memo. 2002-223; Shaw v. Comr., T.C. Memo. 2002-35. Without those logs being available to substantiate the petitioners’ hours, the petitioners were left with satisfying the material participation requirement under the facts and circumstances test. That’s where the presence of the paid manager proved fatal. Thus, the ranching activity was not a hobby, but it was passive.
Combining the passive loss rules with a hobby loss argument is not a new tactic for the IRS (it was recently utilized with respect to a Kansas ranch), but the Robison decision certainly indicates that it can be expected to be used more frequently. But, remember, the IRS, at no point in the audit or litigation in Robison pressed the material participation issue – it was simply stated as an alternative issue in the SNOD. It was Judge Cohen that sought additional briefing on the issue.
The result in Robison is that the losses will only be deductible to the extent of passive income from the activity. Otherwise, the losses remain suspended until the petitioners dispose of their entire interest in the activity in a fully taxable transaction to an unrelated party. I.R.C. §469(g). That’s exactly what is going to happen. The petitioners are tired of the constant battle with the IRS and will not appeal the Tax Court’s decision. The ranch is for sale.