Tax Article - A Primer on Hobby Loss Rules: Conducting Activities in a Business-like Manner
Target Audience: Tax Accountants and Consultants, CPA's, Business Owners: Construction, HealthCare, Law Frim, Architect & Engineer, Manufacturing & Development, Emerging Growth, and other Professional Service Industries.
Occasionally the Tax Court reminds us of the importance of conducting a business in a business-like manner to protect a business from the hobby loss challenge. A recent example is the Mitchell case in which the Tax Court disallowed losses related to a farming activity. Read on to see what you can take away from the Mitchell case to help protect yourself from a hobby loss challenge, but first let’s go over the basic business loss rules.
Back to the Basics
Let’s begin by reviewing the general rules. Losses sustained in a for-profit business are allowed as deductions against other taxable income. However, deductions sustained in an activity not engaged in for profit (hobby) are governed by Code Section 183. Expenses that are deemed to be related to a hobby are allowed only to the extent of the income produced by the activity. Furthermore, they are deductible only on Schedule A as a miscellaneous itemized deduction unless they are otherwise deductible without regard to the profit motive (i.e., real estate taxes).
But isn’t there a safe harbor? A statutory safe harbor exists that, if met, causes a presumption that the activity is a for-profit endeavor. If the safe harbor is not met, the taxpayer can still establish a profit motive using subjective factors (discussed later). To meet the safe harbor, an activity must generate a profit in at least three of five years (two of seven years for activities involving horse racing, breeding, or showing) ending with the tax year in question [IRC Sec. 183(d)]. If this safe harbor is met, the burden of proof for lack of profit motive is shifted to the IRS. The safe harbor presumption applies only for the third (or second) profitable year and all subsequent years within the five-year (or seven-year) safe-harbor period, beginning with the first profitable year [Reg. 1.183-1(c)].
Now for the real life example of what not to do.
The Facts and Issues of the Mitchell Case
Facts. Austin Mitchell, an attorney/CPA in public practice, has operated since 1992 his inherited 100-year old family farm. Mitchell worked on the family farm during his childhood through his college years. Mitchell and his family moved onto the family farm in late 1991 to care for his ailing mother. He then inherited the farm shortly after her death in April 1992. Since that time, Mitchell has worked evenings and weekends from mid-April to September planting seedlings and clearing land for weed control. Mitchell enjoys the physical labor, believing that he might derive health benefits from it as well.
Mitchell’s brother-in-law, Harris, an experienced farmer, has planted, harvested, and bailed hay on the family farm since 1971. Harris was first hired by Mitchell’s mother to perform work on the farm, including haying. In addition, Harris rented the pastures from her to graze his cattle. After Mitchell inherited the farm, Harris continued to hay on the family farm at his own expense, keeping the harvested hay in exchange for taking general care of the land. Also, Harris could graze his cattle on the pasture land in exchange for liming and fertilizing the hayfields. In 1999, Mitchell and Harris changed their arrangement to “custom bailing on the shares” where Harris would perform all the haying work and keep 50% of the hay. At that time, Harris agreed to pay pasture land rent to Mitchell. Mitchell agreed to pay Harris for the services to lime, fertilize and maintain the fences. The fees Mitchell paid Harris for his services exactly offset the pasture rent Harris paid Mitchell.
Mitchell occasionally consulted with neighboring farmers or farming clients of his professional services firm; however, he did not consult with experts on how to make the farm more profitable. He did not have a written business plan, separate checking account, or separate books and records for the family farm. The farm reported losses from 1992 to 2000 totaling approximately $80,000 to $90,000.
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Issues. The court considered two issues, the first one was whether Mitchell conducted his farming activity for profit during the 1998, 1999, and 2000. Second, whether Mitchell is liable for the accuracy-related penalty for the years at issue.
Mitchell's Farming Activities: One or Multiple
Often the IRS will attempt to segregate activities as unrelated because this makes it harder for the taxpayer to establish a profit motive. The taxpayer on the other hand, will typically attempt to aggregate them. This was true in the Mitchell case which involved three activities: tree-planting, mature timber harvesting, and haying. Treas. Reg. 1.183-1(d)(1) provides that all facts and circumstances must be taken into account to make the determination of one or multiple activities. Generally, the most significant facts and circumstances in making this determination are the following:
The court considered these and other factors in determining that the activities could be aggregated. The other factors considered include:
While the IRS argued that the tree-planting, mature timber harvesting, and haying undertakings were three separate activities the Tax Court found (for Mitchell) after considering these factors that they could be aggregated into one farming activity.
Presumption of Safe Harbor Profit Motive
Mitchell argued that the presumption of a profit motive (safe harbor) applied for 1998 and 2000 (the loss years at question) because the gross income derived from the combined farming activities exceeded the deductions attributable to the activities in 1999, 2001, 2003, and 2004. However, the court disagreed noting that the presumption applies only after the third profit year. Since profits were not reported in three or more of the years 1994 to 1999, the presumption or safe-harbor does not apply for either 1998 or 2000. This reminds us that safe harbor protection only applies after the third (second for horse racing, breeding, or showing) profitable year.
Application of the Subjective Factors in Determining a Profit Motive
When the safe harbor profit motive presumption does not apply, the regulations provide a list of factors to consider in examining the facts and circumstances to establish a profit motive. (See Appendix 1 for these factors in the form of a checklist that you can use with your clients.) Note that several of the factors necessary to determine that the business was operated in a business-like manner were missing from the Mitchell facts. The lack of a separate bank account for the farming activity, coupled with the lack of complete and accurate books and records were unfavorable. There was no written business plan, nor any evidence that showed he considered how to make the farming activity profitable before engaging in it. While Mitchell appeared to change his agreement with Harris several times, there was only one change that the IRS considered substantive (the 1999 change in the haying arrangement where Mitchell received 50% of the hay). This one change was not enough to offset the absence of books and records and other “business-like” manner indicators.
Other unfavorable factors included that Mitchell did not seek expert advice on how to operate the farm profitably. While he devoted time working on the farm, he did not explain how the work he performed related to making it profitable. Mitchell intended to give the family farm to his sons rather than sell it so appreciation of the land was not available to help establish a profit motive. While he had worked on the family farm while growing up, he did not prove that the family farm was financially successful during those years. The history of losses Mitchell claimed from the farm activity since 1991 totaled between $80,000 and $90,000. While farming did involve hard manual labor, Mitchell acknowledged that he enjoyed doing the work. In addition, the fact that his family lived on the farm added to the personal pleasure/recreation element.
The IRS did consider that the farming losses were small in comparison to Mitchell’s marginal income tax bracket, this factor favored Mitchell. However, it wasn’t enough to offset the numerous unfavorable factors, so the court sided with the IRS concluding that Mitchell did not conduct the farming activity with an actual and honest objective of making a profit in 1998 or 2000.
In order to protect your deductions remember to do the following:
When the activity involves an element of personal pleasure or recreation (or could be perceived to by the IRS), it is even more important to document the factors indicating the business is operated for profit. This is also true if you have substantial sources of income beyond this activity.