Where’s the Line Between Start-Up Expenses, the Conduct of a Trade or Business and Profit Motive?

Overview

January 27’s article dealt with the deductibility of start-up costs.  You may read the post here:  https://lawprofessors.typepad.com/agriculturallaw/2021/01/deducting-start-up-costs-when-does-the-business-activity-begin.html  In that article, I noted that start -up costs can be deducted by election in the year the business begins – at least to an extent.  Of course, businesses that are starting out often incur tax losses.  The business activity may eventually turn a profit, but how long can a business activity incur losses before the IRS says the business activity is really a hobby and denies loss deductibility.  Start-up expenses; whether a trade or business activity is involved; when when a business activity begins; and how long losses can be sustained and not be deemed to be a hobby – these are all intertwined issues for new business activities.  In addition, if an activity is deemed to be a hobby, the impact of the Tax Cuts and Jobs Act TCJA) for tax years beginning after 2017 is harsh.

Taking another look at tax issues encountered by many new business activities – it’s the topic of today’s post.

Tax Code Rules

For a business expense to be deductible, it generally must be “ordinary and necessary” or be an investment expense.    I.R.C. §§162; 212.  Investment-related deductions under I.R.C. §212 have largely been eliminated by the TCJA.  That puts the emphasis on deductions to be tied to a trade or business activity so that they can be deducted under I.R.C. §162.  The trade or business must be conducted with a profit intent.  If not, the activity is deemed to be a hobby and associated losses are “hobby losses.”

What is a “hobby”?  A “hobby” under the Code is defined in terms of what it is not.  I.R.C. §183.  A hobby activity is essentially defined as any activity that a taxpayer conducts other than those for which deductions are allowed for expenses incurred in carrying on a trade or business or producing income.  I.R.C. §§162; 212.  The determination of whether any particular activity is a hobby activity or not is based on the facts and circumstances of each situation.  It’s a highly subjective determination. 

But the Code provides a safe harbor.  I.R.C. §183(d).  Under the safe harbor, an activity that doesn’t involve horse racing, breeding or showing must show a profit for three of the last five years, ending with the tax year in question.  It’s two out of the last seven years for horse-related activities.  If the safe harbor is satisfied (either for horse activities or other activities, a presumption arises that the activity is not a hobby.  The safe harbor applies only for the third (or second) profitable year and all subsequent years within a five-year (or seven-year) safe-harbor period that begins with the first profitable year.  Treas. Reg. §1.183-1(c). 

What about losses in early years?  As noted above, the safe harbor applies only after a taxpayer incurs a third profitable year within the five-year testing period.  That means that only loss years arising after that time (and within the five-year period) are protected.   Losses incurred in the first several years are not protected under the safe harbor.  It makes no difference whether the activity turns a profit in later years.

Postponing the safe harbor.  It is possible to postpone the application of the safe harbor until the close of the fourth tax year (or sixth (for horse activities) after the tax year the activity begins.  I.R.C. §183(e).   This is accomplished by making an election via Form 5213 to allow losses incurred during the five-year period to be reported on Schedule C.  Thus, if the activity shows a profit for three or more of the five years, the activity is presumed to not be a hobby for the full five-year period.  The downside risk of the election occurs if the taxpayer fails to show a profit for at least three of the five years.  If that happens, a major tax deficiency could occur for all of the years involved.  Thus, filing Form 5213 should not be made without thoughtful consideration.  For example, while the election provides more time to establish that an activity is conducted with a profit intent, it will also put the IRS on notice that an activity may be conducted without a profit intent.  It also extends the statute of limitations for a tax deficiency (and refund claims) associated with the activity.  See, e.g., Wadlow v. Comr., 112 T.C. 247 (1999).    

The burden of proof.  Satisfaction of the safe harbor shifts the burden to prove that the activity is a hobby (i.e., lacks a profit motive) to the IRS.  That means that the IRS can rebut the for-profit presumption even if the safe harbor is satisfied – although it doesn’t tend to do so without extenuating circumstances.   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 farmer or rancher attempting to deduct the losses. See, e.g., Ryberg v. Comm’r, T.C. Sum. Op. 2012-24. 

To assist in making this determination, the IRS has developed nine factors (which are contained in the Treasury Regulations) to be examined in determining whether the requisite profit motive exists.  Treas. Reg. § 1.183-2(b).  Those factors are: 1) the manner in which the taxpayer carries on the activity; 2) the taxpayer’s own expertise or the expertise of the taxpayer’s adviser(s); 3) the time and effort the taxpayer expends on the activity; 4) the expectation that assets used in the activity may appreciate in value; 5) the taxpayer’s success in carrying on similar activities; 6) the taxpayer’s history of income or loss with respect to the activity; 7) the amount of occasional profits, if any, from the activity; 8) the taxpayer’s financial status; and 9) whether there were any elements of personal pleasure or recreation that the taxpayer derived from the activity.     

Showing a Profit Intent - Recent Case

While the IRS is presently not aggressively auditing farming activities that it believes are not conducted with the requisite profit intent.  Just a few days ago, the Tax Court decided a hobby loss case where the taxpayer failed to clear the bar on showing a profit intent for the farming activity that he was attempting to start.

In Whatley v. Comr., T.C. Memo. 2021-11, the petitioner had retired from the banking industry.  Before he retired, in 2003 he purchased a 156-acre tract that had been a timber farm and cattle operation for 350,000.  134 acres of the tract was timber.  It was not an active timber or farming operation when he bought it, but was in the Conservation Reserve Program (CRP).  In 2004, he bought an additional 26 contiguous acres.  That tract had a new (built in 2000) home on it along with a barn and a small caretaker’s house.  On the advice of his long-time CPA, the petitioner created an LLC in 2004.  He owned 97 percent of the LLC, his wife was a one percent owner, and their children owned the balance.  He never transferred the land to the LLC.

For several years, he spent about 700 hours annually maintaining the property without any formal business plan.  There was no timber harvesting because of the land being in the CRP.  The petitioner would occasionally “thin” the trees to allow sunlight to get through to aid the growth of pine trees which would be harvested after many years of growth.  The petitioner testified that he had wanted to introduce cattle “from day one.”  He had consulted with two cattle experts for advice, but he couldn’t remember when the consultations had occurred or what he had learned from those experts.  In reality, however, the petitioner didn’t actually have cattle on the property until at least 2008 – soon after he learned that he was going to be audited.  He also testified that many of what he claimed to be cattle-related activities were really preparatory activities so that cattle could be on the property at some future date.  Those preparatory activities included the installation of fencing and barn repairs.

He ran the LLC very informally, keeping no traditional accounting records such as ledgers, balance sheets, income statements, or cashflow statements.  He didn’t expense the cost of insurance for the property and didn’t maintain a separate bank account or any separate banking records during the years at issue.   For those years, the petitioner filed Form 1065 (partnership return) stating that the LLC’s principal business activity was a “Farm” and the principal product or service was “Cattle.”  This was also how the activity was characterized on the petitioner’s Schedule F.  The petitioner’s tax returns were professionally prepared by the petitioner’s CPA even though the petitioner had a “cattle farm” with no cattle, and a “tree farm” with no timber.  He showed a tax loss from the property for tax years 2004-2008 on Schedule F, with the losses stemming largely from depreciation claimed on two buildings on the property.

The IRS notified the petitioner in early 2008 that it was going to audit the LLC for tax year 2005.  Upon receiving the audit notice, the petitioner put together a forest management plan and brought cattle to the property.  The IRS later expanded the audit to include tax years 2004 and 2006-2008. The IRS disallowed the losses on the basis that the petitioner’s activity on the land was not engaged in with a profit intent.  The IRS also disallowed a large charitable deduction for the petitioner’s deduction of a permanent conservation easement. 

The Tax Court agreed with the IRS, finding that all nine factors of the I.R.C. §183 regulations favored the IRS.   This was despite the Tax Court’s recognition that the facts suggested that the petitioner was attempting to transform the property into a viable farming business. 

TCJA Change

The TCJA suspends miscellaneous itemized deductions for years 2018-2025.  Thus, deductions for expenses from an activity that is determined to be a hobby are not allowed in any amount for that timeframe.  I.R.C. §67(g).  But all of the income from the activity must be recognized in adjusted gross income.  That’s painful, and it points out the importance of establishing the requisite profit intent. 

Conclusion

Hobby activities involving agricultural activities (especially those involving horses) have been on the IRS radar for quite some time.  That’s not expected to change.  It’s also an issue that some states are rather aggressive in policing.  See, e.g., Howard v. Department of Revenue, No. TC-MD 160377R, 2018 Ore. Tax LEXIS 35 (Ore. Tax Ct. Mar. 16, 2018); Feola v. Oregon Department of Revenue, No. TC-MD 160081N, 2018 Ore. Tax. LEXIS 48 (Ore. Tax. Ct. Mar. 27, 2018).  It’s also not an issue that the U.S. Supreme Court is likely to review if the taxpayer receives an unfavorable opinion at the U.S. Circuit Court of Appeals level.  See, e.g., Hylton v. Comr., T.C. Memo. 2016-234, aff’d., No. 17-1776, 2018 U.S. App. LEXIS 35001 (4th Cir. 2018), cert. den., No. 18-789, 2019 U.S. LEXIS 966 (U.S. Sup. Ct. Feb. 19, 2019).

Clearly, the petitioner’s CPA did Whatley did him no favors.  The tax planning and counsel was egregious.  Equally clear, however, was that the petitioner in Whatley was engaged in activities with the intent of ultimately conducting an operating farm.  But does that ultimate end-goal of an activity matter?  Given the nine-factor approach of the regulations, it appears that the IRS could swoop in with a well-timed audit and wipe out what would otherwise be legitimate business expenses.  Should a broader, more long-term view of new business activities be undertaken to evaluate whether a profit intent is present?  In other words, is there a better way to evaluate alleged hobby activities than the present nine-factor approach?  The U.S. Court of Appeals for the Seventh Circuit certainly thinks so.  In Roberts v. Comr., 820 F.3d 247 (7th Cir. 2016), the court called the nine-factor text “goofy” and took issue with start-up expenses being denied as hobby loss expenses.  The Whatley case is appealable to the Eleventh Circuit.

For now, the nine-factor test of the regulations is what is used to determined profit intent and whether the hobby loss rules apply.  As noted, at least one U.S. Circuit Court of Appeals is dissatisfied with the nine-factors.  Will another Circuit follow suit?  Only time will tell whether the nine-factor test has outlived its usefulness.