Not Quite Hobby Loss Rules, But Passive?
If you specialize in taxation, you are taught that the general rule for hobby loss rules to kick in, would be if you lost money in your business for a period of three years.
In the case of Robison et ex v. Commissioner T.C. Memo 2018-88, we have a situation where the end result is the same, no matter the outcome of the case. IRC §183, or the Hobby Loss Rules state:
In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section.
The husband and wife in this case worked very successful jobs. In 1999, they purchased a cattle ranch in Utah and then, in 2000, formed Robison Ranch, LLC, with husband and wife each owning 50 percent of the ranch. From 2000 – 2015, the LLC filed Form 1065 and never made a profit. From 2000 – 2015 the couple reported over $9 million in losses from the ranch as deductible.
The couple employed a ranch manager that paid the bills and did monthly financials. They hired a CPA to do their tax returns for the ranch and began breeding Paint Horses, but switched to Quarter-Horses and then to cattle.
IRS determined that the Robisons’ ranching activity was not an activity engaged in for profit within the meaning of IRC §183 and disallowed the loss deductions relating to the ranch that the Robisons claimed on their Schedules E. It alternatively argued that if the Robison’s were found to be engaged in the ranching activity with an intent to realize a profit, their loss deductions should be limited by the passive activity loss (PAL) rules of IRC §469.
For 2000 through 2014, IRS assessed the Robisons with a total deficiency of over $1 million. On the hobby-loss issue, the US Tax Court stated that the Robisons did engage in the ranching activity with a profit motive.
They conducted their activity in a business-like manner, sought out knowledgeable experts and devoted substantial time and effort to running the ranch. The Court gave more weight to these factors than to those favoring the IRS, namely the long history of losses from the ranching enterprise and the fact that the Robisons had substantial other income that allowed them to continue a money-losing enterprise (and make good tax-saving use of the losses). There was inconclusive evidence on whether the enterprise could appreciate in value sufficiently to recoup losses between the years at issue and the hoped-for profitable future.
Here is the problem: I have had to do this myself and I can tell you it isn’t easy. How do you prove material and active participation in a business?
Business owners don’t typically clock in and out. To prove the losses weren’t PALs, the couple presented records that, in the Court’s opinion, were non-contemporaneous with the exception of the minutes kept from the weekly conference calls the Robisons had with ranch employees.
The annual log the Robisons provided for each tax year reported hours assigned to activities years after the fact, in preparation for trial, and were based solely on their judgment and experience as to how much time the activities must have taken them. The records also failed to show what specifically the Robisons did on a daily basis and exactly how much time they spent on matters directly relating to the ranch, making it impossible to conclude that their activity was conducted outside of an investor-type capacity.
Contemporaneous means that the records must be kept as the event is occurring. How I proved material and active participation of the owner was that the owner wrote all the checks for the business and was at the business location signing for inventory.
The end result is that the cattle ranch was not found to be within the meaning of hobby-loss rules, however, the losses are suspended due to PAL rules.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...