IRC Section 162(a) allows as a deduction “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”. If an activity is not engaged in for profit, no deduction is allowed except to the extent of gross income derived from the activity. IRC Section 183(b). Therefore, losses are not allowable for an activity that a taxpayer carries on primarily for sport, as a hobby, or for recreation. To be entitled to deductions under Section 162(a), the taxpayer must show that he or she engaged in the activity with an actual and honest objective of making a profit. Although the taxpayer’s expectation of profit does not have to be reasonable, the intent to make a profit must be genuine.
The Section 183 regulations set forth a nonexclusive list of nine factors the IRS and courts use in determining whether a taxpayer conducted an activity with the intent to earn a profit. No factor or group of factors is controlling, nor is it necessary that a majority of factors point to one outcome. The factors to be considered are: (1) the manner in which the taxpayer conducts the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort spent by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) elements of personal pleasure.
In Wondries, the taxpayers had operated many successful business enterprises, including 23 car dealerships. According to the court, the taxpayer husband had converted half of the dealerships from losing enterprises to profitable businesses. In 2004, the taxpayers were seeking to diversify their business enterprises by purchasing a cattle ranch. Their intent was to raise and sell cattle on the ranch and have guided hunting expeditions. The taxpayers provided a detailed business plan to the bank that financed the purchase, which outlined how the taxpayers would be making mortgage payments and making a profit. The court noted that the taxpayers’ alternative approach was to hold the property for investment, since they purchased it for $2 million – a full $1 million under the asking price of $3 million.
Unfortunately, the ranch never realized a profit or broke even. During the years 2015, 2016 and 2017, the years before the court, the ranch had gross income of $892, $12,485 and $10,627, respectively and losses of $473,901, $223,095 and $229,124, respectively. The taxpayers reported total income during those same years from their other businesses of $11,099,715, $12,376,821 and $9,259,687. These loss and income amounts typically do not result in a taxpayer win.
However, in holding for the taxpayers, the court noted the following:
- Because they had no ranching experience, the taxpayers hired a very qualified foreman to run the ranch, who had managed two profitable ranches close to the taxpayers’ ranch.
- The foreman ran all aspects of the ranch and had a separate checkbook and credit card for ranch expenses.
- The taxpayers personally maintained very good and complete financial and payroll records for the ranch, and periodically engaged an accountant from one of their automotive businesses to review the ranch accounting work.
- “Petitioner husband’s management style for the ranch is similar to his management style for the automotive businesses: He hired experienced individuals to oversee the businesses’ day-to-day affairs, and he checked in with these managers intermittently for status updates”.
- The taxpayers quickly pivoted to an investment focus after they discovered that raising cattle was cost prohibitive, partially due to an unexpected drought, and that the ranch was too small to sustain wild animals for guided hunts. In addition, the insurance requirements and attendant liability risks significantly outweighed the potential revenue that providing hunting expeditions could yield.
- The taxpayers made significant improvements to the property and hoped to eventually sell the property at a gain. The foreman and third-party contractors completed most of the improvements, but the taxpayers would pitch in when they visited the ranch.
- The taxpayer husband testified at trial that the property was worth between $5.5 and $6 million and was listed for sale at $6.7 million.
- If the property sold at the lower end of the taxpayers’ estimates, they would still make a profit.
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