Tax Court: Create a Profit Motive to Reap Tax Rewards on Ranch Lossesby
Like the 1960s TV show Green Acres, wealthy individuals with jobs in the city may dabble in ranching or farming operations or quit to run the country place full-time.
In a recent case, Welch, TC Memo 2017-229, 11/20/17, the IRS contested the losses of such a “gentleman farmer” that ran into the millions of dollars. But the Tax Court ruled that the taxpayer had established a profit motive and allowed the losses.
If an activity is considered a hobby, not a business, deductions are generally limited to the amount of hobby income. Conversely, a business might be able to claim a loss. The key distinction is often whether you’re engaging in the activity to turn a profit.
Under the prevailing regulations, the courts have relied on the following nine factors to make this determination:
- How the taxpayer carries on the activity.
- The taxpayer’s expertise.
- The time and effort expended by the taxpayer in carrying out the activity.
- Any expectation that assets used in the activity (e.g., land) may appreciate in value.
- The taxpayer’s success in other activities.
- The taxpayer’s history of income or losses from the activity.
- The relative amounts of the profits and losses.
- The taxpayer’s financial status.
- Whether the activity provides recreation or involves personal motives.
The taxpayer in this recent case had a diverse career, including being an economics professor for 40 years at prestigious colleges and founding a private firm that provided economic and statistical consulting for lawsuits involving discrimination claims. He also maintained a lifelong interest in agricultural activities.
In 1987, the taxpayer purchased land that would eventually become a large operation — almost 8,700 acres on seven tracts of land, with a total appraised value of more than $30 million. The ranch had 25 full-time employees who had annual salaries ranging from $25,000 to $115,000. It also employed part-time ranch hands.
The taxpayer adjusted the workforce over time to meet his changing needs.
During the time he owned the ranch, the taxpayer’s operations focused on these primary areas:
- Cattle. Eventually, the taxpayer settled on a “cow-calf operation” where he raised the herd on the ranch. The calves also were used in the training of cutting horses on the ranch.
- Hay. The ranch grew hay for use in feeding its cattle and horses as well as selling it to third parties as a cash crop. To reduce costs, the taxpayer bought specialized equipment that could spray herbicides at the same time the hay was being fertilized.
- Cutting horses. The taxpayer trained horses to separate individual animals from a cattle herd and then entered the horses in competitions. In 2004, he began construction of a horse center that included specialized buildings, pastures, a training arena and a breeding facility.
Typically, the taxpayer spent long three-day weekends at his ranch, employed a full-time ranch manager and subscribed to numerous farm publications devoted to his ranch interests. He didn’t have a business plan for the ranch.
From 2007 to 2010, the taxpayer reported millions of dollars in losses each year on Schedule F, but the IRS said the activity was not engaged in for profit and denied the losses.
Now the Tax Court sided with the taxpayer. In doing so, it pointed to several critical factors indicating a profit motive:
- The taxpayer carried on the activity in a business-like manner. He kept books and records for each operation to determine the incomes and expenses. The fact that he had no written business plan didn't negate a profit motive.
- The taxpayer employed advisors with substantial business expertise. In addition, he subscribed to numerous professional journals that discussed ranching, cattle and horses, as well as hiring professionals to manage the ranch.
- The long weekends at the ranch and daily communications with managers indicated the taxpayer’s profit motive. He relied on his large staff of experienced managers to keep the ranch running.
- The Tax Court rejected the IRS's argument that the taxpayer needed to expect recovery of all of the ranch’s prior losses to demonstrate a profit motive.
In its discussion of the other factors, the Court established that the outcome was neutral or insufficient to overcome the factors showing a profit motive.
Footnote to the case: The Tax Court didn’t give the taxpayer carte blanche to continue piling up large losses. The IRS could target him again if he doesn’t begin to turn things around.
Ken Berry, Esq., is a nationally known writer and editor specializing in tax, financial, and legal matters. During his long career, he has served as managing editor of a publisher of content-based marketing tools and vice president of an online continuing education company. As a freelance writer, Ken has authored thousands of articles for a...