The Hobby Loss Trap, Part 2
This article will discuss in more detail the process the IRS will use to determine if an activity is a hobby and some related court rulings. As stated last month, if the IRS is successful in a hobby loss assertion, expenses will be simply disallowed. The current hobby loss rules prohibit taxpayers from deducting hobby expenses against, wages, other investment income and even hobby income. In 2017 and prior years, a taxpayer could at least deduct ordinary and necessary “hobby expenses” up to the amount of “hobby income”. To reiterate again, hobby expenses are no longer deductible.
The IRS uses nine factors in determining an activity as a hobby. These factors historically have carried different weights at the three levels of an IRS examination, the agent level, the appeals level and in the courts.
Agent Level
The determination of whether an activity is engaged in for profit is based on the facts and circumstances of each case and can be very subjective. Per the Treasury regulation Sect 1.183-2(b) there are 9 relevant factors that the IRS will consider in determining the profit making intent. The following excerpts from the 81 page IRS agent training guide that was prepared by the IRS Market Segment Specialist Program (“MSSP”) provides some insight into how the IRS will review these factors. (Italics are our comments)
“Factor 1: The Manner in Which the Taxpayer Carries on the Activity
“Books and Records Used in the Activity” (The IRS is looking for detailed records. Take time to prepare them. Separate personal items from business by having separate bank accounts and when practical conduct the activity in a legal entity like an LLC)
“Business Plan” “The taxpayer should have a formal written plan. This plan should demonstrate the taxpayer’s financial and economic forecast for the activity…A business plan should show a short range and long range forecast for the activity. The forecast should allow for changes due to potential unforeseen and fortuitous circumstances.” (The IRS is looking for detailed budgets, cost analysis and long term forecast)
“Methods of Operation” ,,,denote changes in the method of operation over the years and indicate why these changes were initiated. (The IRS is looking for cost analysis and market analysis. They are also looking for documentation of changes in operations and adjustments in your long-term planning as a result of those analyses. Minutes of meetings is one example of this documentation)
“Efficiency of Operation” “denote whether the taxpayer is making changes to the operation that will result in improved operational efficiency. “
“Factor 2 The Expertise of the Taxpayer or His or Her Advisors”
“The examiner should document the expertise and knowledge of the taxpayer regarding the activity. The examiner should also document any advisors or experts that the taxpayer has used. Documentation should be prepared which shows specific instances where the taxpayer has followed the advice of the advisor. Documentation should also show how the advice affected the operation of the activity. The examiner should especially note instances when the taxpayer has ignored the recommendations of the advisor and why that decision was made.” (Document your communication with advisers)
“Factor 3: The Time and Effort Expended by the Taxpayer in Carrying on the Activity”
“The amount of time devoted to the activity may be an indicator of profit motive. If the taxpayer employs competent and qualified individuals to operate the activity, then the taxpayer’s time and effort will be reduced.”
“The time analysis should precisely detail how much time the taxpayer devotes to each task related to the activity. The examiner should consider whether IRC 469 Passive Activity provisions might be applicable. IRC 469 could provide an alternative position for IRC section 183.” (Maintain contemporaneous records of personnel activities to meet the 500 hour rule. The IRS was successful in the Robison Case with the alternative position because of bad documentation)
“Factor 4: The Expectations That the Assets Used in the Activity May Appreciate in Value”
“According to the Treasury Regulations, Factor 4 states that the term “profit” also includes the appreciation of assets, such as land, used in the activity. An overall profit may occur, in spite of losses from current operations, if the appreciation of the assets is realized.”
“The examiner needs to determine if a potential for asset appreciation exists. The examiner can use comparables for this determination. The examiner also needs to determine whether the operation of the activity and the holding of the land are considered a single activity or separate activities.”
“In the instances of single activities, the history of losses from current operations will be offset by the future potential gain. In the instances of separate activities, the taxpayer cannot offset current operating losses by future potential gains. A determination of separate activities will result in the taxpayer not meeting Factor 4.” (Note the new term “activity” verses “trade or business” and the need to identify all “activities” in your operations and the assets that are related to each i.e. cattle, citrus)
“Factor 5: The Success of the Taxpayer in Carrying on Other Similar or Dissimilar Activities”
“The examiner needs to document the financial successes that the taxpayer has had with other activities. A statement should also address specific instances where the taxpayer has abandoned any activities.” (Past and present sold or abandoned)
“Factor 6: The Taxpayer’s History of Income or Losses with Respect to the Activity”
“Factor 6 is one of the most important factors of the nine. This factor supports the framework of this Code section.”
“IRC section 183 focuses on the lack of profit potential for a specific activity. The question regarding profit motive is initially triggered by history of losses. For this reason, the development of this relevant factor provides the framework for this section. Examiners should not base any conclusions using this relevant factor alone.” (Detailed budgets, and long-term forecast are a defense against this shortsighted view by the IRS. Documenting intentions of growing a herd may result in expectations of 8 to 10 years of losses while heifers are retained to grow the herd. Alternatively starting a ranching activity by purchasing a herd might result in expectations of only 3 years of losses. This is why the IRS accepts the Safe Harbor rule once met)
“Factor 7: The Amount of Occasional Profits, if Any, Which Are Earned”
“The examiner should consider the amount of occasional profits that the activity may generate.”
“Factor 8: The Financial Status of the Taxpayer”
“In general, taxpayers who have other substantial sources of income have the financial wherewithal to sustain a history of losses with respect to cattle or horse activities. Some taxpayers actually derive a tax benefit from participation in these activities since the losses offset the other sources of substantial income.”
“Factor 9: The Elements of Personal Pleasure or Recreation”
“The examiner needs to address the pleasurable and recreational aspects of the activity. The examiner should remember that taxpayers are willing to overlook the drudgery of certain tasks when the pleasurable aspects outweigh the negatives.“
Note that meeting of five of the nine factors results in taxpayer wins at the audit level. Meeting those factors require good records and documentation. Rule six is the most important for the agent.
Appeals
The IRS appeals process gives the rancher a second bite at the apple. The Appeals Officer may consider the hazards of litigation. He will review how the courts weight the nine factors and will not be stuck on the “five-out-of-nine” exam manual’s position. Hobby losses are one of the most frequently litigated issues in tax. Given that fact, a rancher should take advantage of appeals. Besides the benefit of the hazard of litigation, it gives an opportunity to review the examination’s agents’ files and documentation for errors and weak positions. Additional effort is required but is usually worth the trouble. From our experiences, a taxpayer rarely wins all of the issues at this level. The appeals agent is motivated to settle the case within reason and will usually use a percentage because of the litigation hazard to settle an issue. Now, if the examination agent is unreasonable, the appeals officer has settled the whole case in the rancher’s favor.
The Courts
There are court cases that show the importance of good documentation. An example of this was the case of Garbini v. Commissioner, T.C. Summary Opinion 2004-7. This involved the issue of whether the taxpayers were engaged in an activity for profit in connection with a cattle and horse breeding operation in Myrtle Creek, Oregon. Mr. Garbini, the taxpayer, did not maintain good books and records. He never prepared budgets or market forecast which supported strategies for a profitable business venture. He had no documentation that indicated what efforts he actually made to reduce expenses. Mr. Garbini worked on the ranch almost every day and employed one full-time ranch hand. He had no sales. Mr. Garbini testified, without any documentation, he bought the property for $566,000 in its undeveloped condition, and at the time of trial it was worth $15 million. The court ruled to disallow the deduction in the years in question since the taxpayer had minimal records to support his profit intent.
In the Williams case, in Welch, T.C. Memo. 2017-229, a ranching activity was deemed to have a profit motive despite years of losses. The taxpayer was a college economics professor for 40 years. The taxpayer did not have a written business plan for the ranching activity, but the court determined that in this specific case, that did "not negate a profit motive." Points the court cited as favoring the taxpayer included that the taxpayer made changes to the overall ranching activity three times due to a lack of profit; had obtained a degree in agricultural economics; and employed experienced ranch employees including a ranch manager. In addition, although he spent four days per week on other nonranching endeavors, the taxpayer was still in daily contact with the ranch manager.
In Williams, T.C. Memo. 2018-48, From 2000 to 2015, the court determined the activity was a hobby. The taxpayer reported an overall net loss of $1.7 million from the ranching activity, while reporting income from non-Schedule F activity totaling $3 million. Points that the court found weighed against the taxpayer were, he did not devote sufficient time to the ranching activity, he never documented any review of the ranching activity's financial statements with either the bookkeeper or the CPA, he did not establish a formal written business plan and, after five years of operating the ranch at a loss, the taxpayer never changed the operating structure of the ranching activity.
The IRS feels that factor 6, the base for safe harbor rule we discussed in last month’s article, is the most important factor for consideration. However, the Courts seem to believe that first factor is the most important. When a taxpayer operates his activities in a very business-like manner with well documented profit plans, accounting records, cost analysis and good communications showing reasonable efforts to achieve goals that will lead to a profit, the courts have ruled in the taxpayer’s favor even when there are years of losses. However, those that do not have those records, are likely be a victim of the “Hobby loss disallowance provision”.
Summary
Ranchers will need to spend more time during the year to document their activities. They should keep in mind the difference between participation verses investor reviews. Before year-end he should determine the appropriate amount of taxable income or in certain cases, net operating losses per activity. Remember that the IRS has changed the rule from trade or business to an “activity.” Be careful to develop documentation for each activity that occurs in your operation. Growing blueberries, hay, timber, hunting leases and cattle breeding are just a few items that could be considered as separate activities. It is very important to maintain good accounting records which include a short-term and long-term business plan, budgets, cost control analysis and documented communication of decision to improve the potential profitability of each of your activities in your operations. Consideration should be given to the more burdensome accounting and recordkeeping that accompany the NOL requirements. The safe harbor rule is complicated and is not as protective as they seem. Try to meet it, if practical, but do not rely on it as your only defense against the hobby loss rule. Document your participation in your activities to also avoid the passive activity rules. Your financial advisor should be able to provide some guidance to help you lower your exposure to the hobby loss provisions and the passive activity rules.