Hobby Loss and Ranches – An Overview of Section 183
By Mary E. Wood and Josh O. Ungerman on April 5, 2024
If a taxpayer undertakes an activity with the objective of making a profit, the expenses related to the activity are generally deductible and any excess losses related to the activity can be utilized in future tax years (subject to applicable net operating loss limitations). If the activity is deemed to be subject to the "hobby loss rules" of Internal Revenue Code Section 183, however, the expenses and losses related to the activity are generally disallowed. Much to the chagrin of taxpayers in farm and ranching businesses, the IRS often comes in after the fact in an examination and makes a determination that the farm and ranching activity is not engaged in for profit and, thus, subject to the punitive hobby loss limitations. A well thought out and thorough challenge to an IRS examination is imperative.
The IRS is currently targeting taxpayers with farming and ranching activities and labeling the ranch activities as "hobbies" to disallow expenses from a variety of activities such as horse breeding and racing, cattle breeding, exotic animal breeding and exotic game hunting to name a few. A hobby loss determination is devastating to these business activities as taxpayers are required to report the income associated with the activities but are not able to deduct any expenses or claim losses associated with the activity that generated the income. Put simply, if the IRS determines that the activity is a hobby rather than a business activity engaged in for profit, only the revenue related to the activity will be considered for federal income tax purposes.
The hobby loss rules presume that a taxpayer is engaged in a trade or business, and therefore not engaged in a hobby, if a net profit is generated by the activity in question in three of the previous five consecutive years, ending with the taxable year at issue. In the case of operations involving horses, which are often challenged by the IRS under the hobby loss rules, the taxpayer must show a net profit in two of the last seven years.
If a taxpayer does not satisfy the profit presumption test under the yearly profit analysis, the statute and relevant case law look to a taxpayer’s subjective intent to determine if the activity was engaged in with the requisite profit motive. A hobby loss determination requires a very fact-intensive analysis, and the IRS position is that objective facts hold greater weight than a taxpayer’s “self-serving” statements of intent. Further, the taxpayer has the burden of proof with respect to proving the required profit motive.
The Section 183 regulations outline nine objective factors to aid in determining whether an activity is engaged in for profit. All factors are weighed in the analysis and no one factor is determinative. The nine-factor test analyzes the following:
1. The extent to which the taxpayer carries on the activity in a businesslike manner.
This factor evaluates whether the taxpayer is operating the activity as one would expect a business to operate. This is typically the most heavily weighted factor in hobby loss cases. Maintaining accurate books and records and operating the activity in the same manner as comparable profitable businesses is evidence that an activity is carried on in a businesslike manner. Changing operating methods and adopting new techniques have also been found to weigh in favor of the taxpayer under this factor.
2. The taxpayer’s expertise or reliance on the advice of experts.
If the taxpayer has studied the accepted business, economic, and scientific practices of an activity and/or has consulted with or hired an expert regarding the operation of the activity, this factor will likely weigh in favor of the taxpayer. However, if the advice of experts is not followed by the taxpayer, this factor could weigh against the taxpayer. Attending seminars, trade meetings, reading books or purchasing other learning aids will also weigh in favor of the taxpayer.
3. The time and effort the taxpayer expends in carrying on the activity.
If the taxpayer spends a large amount of personal time carrying on the activity under examination, this factor will likely weigh in favor of the taxpayer. However, the fact that a taxpayer devotes only a limited amount of time to the activity does not necessarily signify a lack of profit motive if the taxpayer employs competent and qualified persons to assist in the activity's operations.
4. The expectation that the assets used in the activity may appreciate in value.
A “bona fide expectation” that the assets used in an activity may appreciate in value is also evidence of a profit motive. This appreciation may encompass the value of assets, such as land, used in the activity. Case law has indicated that an overall profit is present if net earnings and appreciation are sufficient to recoup the losses sustained in the ‘intervening years’ between a given tax year and the time at which future profits expected. Documenting an expectation of appreciation through land and/or asset appraisals will strengthen a taxpayer’s case for this factor.
5. The taxpayer’s success in other activities.
Evidence of a taxpayer’s success in other similar or dissimilar activities weighs in the taxpayer’s favor. If a taxpayer has previously engaged in similar activities and made them profitable, this success may support that the taxpayer has a profit objective, even though the current activity is presently unprofitable. A taxpayer’s success in other, unrelated activities may also indicate a profit objective. An activity similar to the activity under analysis will be stronger evidence for this factor and the IRS sometimes argues that success in a dissimilar activity is evidence that the current activity is not operated for profit.
6. The taxpayer’s history of income or loss from the activity and 7. The amount of occasional profits, if any.
The sixth and seventh factors relate to the taxpayer’s history of income or losses with respect to the activity and the amount of occasional profits, if any, which are earned. This factor will weigh against a profit motive finding if a taxpayer incurs a long period of losses without an adequate explanation. Examples of adequate explanation are depressed market conditions, drought, casualty losses, theft, weather damages, involuntary conversions or other extraordinary events that make it challenging for the taxpayer to generate a profit. Courts have found that these factors are of lesser importance in some activities, such as farming and ranching, where it has historically been difficult to produce a profit and/or the timeline to profitability is often longer.
8. The taxpayer’s financial status.
The eighth factor focuses on the financial status of the taxpayer in determining profit motive. Courts have noted that the fact that a taxpayer does not have substantial income or capital from other sources may indicate that the activity is engaged in for profit. However, other cases have noted that regardless of the taxpayer’s financial status, there is never a benefit in losing money. Accordingly, this factor is often not given much weight in the hobby loss analysis.
9. The elements of personal pleasure and recreation.
The IRS regulations state that personal motives in carrying on an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. The regulations also provide, however, that personal pleasure derived from engaging in an activity is not sufficient to cause the activity to be classified as a hobby if other factors indicate a profit motive. Accordingly, this factor is not weighted heavily in hobby loss determinations.
Conclusion.
Due to the robust fact-intensive analysis involved in connection with the 9-factor test in IRS hobby loss examinations, it is imperative that taxpayers are prepared to present their position with respect to each factor and gather evidence and/or testimony to support their positions under each factor. The IRS will often view facts in a light that is unfavorable to the taxpayer, so navigating the IRS examination and challenging any IRS adverse determination can have significant economic impact on the subject activities for the years at issue and future years.
If you would like more information about this blog post or any other tax-related matter, please call our office at 214.744.3700 or email Mary Wood at mwood@meadowscollier.com or Josh Ungerman at jungerman@meadowscollier.com.
The IRS is currently targeting taxpayers with farming and ranching activities and labeling the ranch activities as "hobbies" to disallow expenses from a variety of activities such as horse breeding and racing, cattle breeding, exotic animal breeding and exotic game hunting to name a few. A hobby loss determination is devastating to these business activities as taxpayers are required to report the income associated with the activities but are not able to deduct any expenses or claim losses associated with the activity that generated the income. Put simply, if the IRS determines that the activity is a hobby rather than a business activity engaged in for profit, only the revenue related to the activity will be considered for federal income tax purposes.
The hobby loss rules presume that a taxpayer is engaged in a trade or business, and therefore not engaged in a hobby, if a net profit is generated by the activity in question in three of the previous five consecutive years, ending with the taxable year at issue. In the case of operations involving horses, which are often challenged by the IRS under the hobby loss rules, the taxpayer must show a net profit in two of the last seven years.
If a taxpayer does not satisfy the profit presumption test under the yearly profit analysis, the statute and relevant case law look to a taxpayer’s subjective intent to determine if the activity was engaged in with the requisite profit motive. A hobby loss determination requires a very fact-intensive analysis, and the IRS position is that objective facts hold greater weight than a taxpayer’s “self-serving” statements of intent. Further, the taxpayer has the burden of proof with respect to proving the required profit motive.
The Section 183 regulations outline nine objective factors to aid in determining whether an activity is engaged in for profit. All factors are weighed in the analysis and no one factor is determinative. The nine-factor test analyzes the following:
1. The extent to which the taxpayer carries on the activity in a businesslike manner.
This factor evaluates whether the taxpayer is operating the activity as one would expect a business to operate. This is typically the most heavily weighted factor in hobby loss cases. Maintaining accurate books and records and operating the activity in the same manner as comparable profitable businesses is evidence that an activity is carried on in a businesslike manner. Changing operating methods and adopting new techniques have also been found to weigh in favor of the taxpayer under this factor.
2. The taxpayer’s expertise or reliance on the advice of experts.
If the taxpayer has studied the accepted business, economic, and scientific practices of an activity and/or has consulted with or hired an expert regarding the operation of the activity, this factor will likely weigh in favor of the taxpayer. However, if the advice of experts is not followed by the taxpayer, this factor could weigh against the taxpayer. Attending seminars, trade meetings, reading books or purchasing other learning aids will also weigh in favor of the taxpayer.
3. The time and effort the taxpayer expends in carrying on the activity.
If the taxpayer spends a large amount of personal time carrying on the activity under examination, this factor will likely weigh in favor of the taxpayer. However, the fact that a taxpayer devotes only a limited amount of time to the activity does not necessarily signify a lack of profit motive if the taxpayer employs competent and qualified persons to assist in the activity's operations.
4. The expectation that the assets used in the activity may appreciate in value.
A “bona fide expectation” that the assets used in an activity may appreciate in value is also evidence of a profit motive. This appreciation may encompass the value of assets, such as land, used in the activity. Case law has indicated that an overall profit is present if net earnings and appreciation are sufficient to recoup the losses sustained in the ‘intervening years’ between a given tax year and the time at which future profits expected. Documenting an expectation of appreciation through land and/or asset appraisals will strengthen a taxpayer’s case for this factor.
5. The taxpayer’s success in other activities.
Evidence of a taxpayer’s success in other similar or dissimilar activities weighs in the taxpayer’s favor. If a taxpayer has previously engaged in similar activities and made them profitable, this success may support that the taxpayer has a profit objective, even though the current activity is presently unprofitable. A taxpayer’s success in other, unrelated activities may also indicate a profit objective. An activity similar to the activity under analysis will be stronger evidence for this factor and the IRS sometimes argues that success in a dissimilar activity is evidence that the current activity is not operated for profit.
6. The taxpayer’s history of income or loss from the activity and 7. The amount of occasional profits, if any.
The sixth and seventh factors relate to the taxpayer’s history of income or losses with respect to the activity and the amount of occasional profits, if any, which are earned. This factor will weigh against a profit motive finding if a taxpayer incurs a long period of losses without an adequate explanation. Examples of adequate explanation are depressed market conditions, drought, casualty losses, theft, weather damages, involuntary conversions or other extraordinary events that make it challenging for the taxpayer to generate a profit. Courts have found that these factors are of lesser importance in some activities, such as farming and ranching, where it has historically been difficult to produce a profit and/or the timeline to profitability is often longer.
8. The taxpayer’s financial status.
The eighth factor focuses on the financial status of the taxpayer in determining profit motive. Courts have noted that the fact that a taxpayer does not have substantial income or capital from other sources may indicate that the activity is engaged in for profit. However, other cases have noted that regardless of the taxpayer’s financial status, there is never a benefit in losing money. Accordingly, this factor is often not given much weight in the hobby loss analysis.
9. The elements of personal pleasure and recreation.
The IRS regulations state that personal motives in carrying on an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. The regulations also provide, however, that personal pleasure derived from engaging in an activity is not sufficient to cause the activity to be classified as a hobby if other factors indicate a profit motive. Accordingly, this factor is not weighted heavily in hobby loss determinations.
Conclusion.
Due to the robust fact-intensive analysis involved in connection with the 9-factor test in IRS hobby loss examinations, it is imperative that taxpayers are prepared to present their position with respect to each factor and gather evidence and/or testimony to support their positions under each factor. The IRS will often view facts in a light that is unfavorable to the taxpayer, so navigating the IRS examination and challenging any IRS adverse determination can have significant economic impact on the subject activities for the years at issue and future years.
If you would like more information about this blog post or any other tax-related matter, please call our office at 214.744.3700 or email Mary Wood at mwood@meadowscollier.com or Josh Ungerman at jungerman@meadowscollier.com.
