In hobby loss audits, the IRS sometimes views various types of ranching activities as a means of generating tax losses, rather than as a profit-oriented venture. Many cases that have ruled in favor of the taxpayer in livestock and other ranching activities involve people who developed a superior line of animal. Taking a scientific approach to breeding is evidence showing a businesslike approach to the activity.
Careful research into pedigrees, for example, shows a concern for the proper application of genetics to your breeding program. Working with experts to develop a superior nutritional program is also evidence that you are using scientific means to enhance or at least maintain the health of your animals, and this in turn suggests you are operating a business rather than a hobby.
The use of scientific devices to help train animals is important in showing that your venture is conducted in a businesslike manner. For example, many people in the cutting horse industry utilize a “mechanical cow,” which is a device used to help train cutting horses. This product consists of a life-like mechanical cow which travels across a pen on cables. Movements of the cow are controlled by switches, and provide a variety of options.
Another area is agricultural science, which is important in helping to maximize the use of farm land--for instance, to help eradicate problematic weeds. This in turn helps to promote thriving pastures. The use of scientific techniques is also important in that it helps reduce on costs, thus making it more feasible to realize a profit.
Another recurring issue in horse and other livestock activities is “how many” animals constitute a decent sized herd that can generate a profit from breeding and selling. This depends on numerous variables, not to mention the capabilities of the people involved in day-to-day management of the operations. Sometimes the IRS will argue in an audit, that the taxpayer has either “too many” or “too few” animals. In situations where the activity consists primarily of breeding and selling, the auditor might conclude that you have “too few” animals, and that this shows a lack of profit motive. This simply does not make sense. The IRS must keep in mind that there should be business reasons for increasing the size of one's herd. If anything, taxpayers in many Tax Court cases are criticized for having
too many animals.
If there are “too many” animals, the IRS will want to know if you have any plans on culling some of them. Many Tax Court cases refer to the necessity of culling animals that are not being productive in the taxpayer's breeding program.
These and other issues should be addressed not at the time of an audit, but beforehand during the course of developing one's business plan. As I have previously said in this column, one of the best ways I know of helping to insure that you are complying with the IRS hobby loss rule is to obtain a tax opinion letter from a tax attorney. The purpose of this is to analyze your existing operations, to evaluate the strengths and the weaknesses, and to make recommendations according to tax lax on how the operations can be changed in order to meet IRS scrutiny.
There is significant competition in selling animals. It is important to focus one's efforts on successful marketing of one's animals, one by one. To simply “increase” the size of one's herd would present logistical and financial problems that the management of a medium size, quality herd does not pose.
For example, in Ellsworth v. Commissioner, T.C. Memo. 1962-32, the taxpayer was an experienced breeder of cows. The Tax Court said that Mr. Ellsworth's operation “was conducted in an efficient, economically and sound scientific basis when compared to other breeding establishments; that the blood lines of his herd have been constantly improving; and that the prospects of making a profit from the sale of his cattle are considerably improved.”
One final point so often raised in hobby loss cases is the notion that the taxpayer's family has an affectionate attachment to some of the animals, or that they enjoy the farming lifestyle, or that there are significant recreational elements involved. The IRS will try and find any bit of evidence--such as the participation of children--to argue that your primary motivation is recreation, not business. This is really not a proper approach on the part of the IRS because many Tax Court cases have ruled in favor of taxpayers even though there were some elements of personal pleasure and recreation. For example, in an important case that I have previously discussed, Burrus
v. Commissioner, T.C. Memo. 2003-285, the Tax Court ruled in favor of the taxpayer even though family members rode four or five horses on the property, and they held an annual dove hunt and barbecue for about 50 to 75 guests. Also, the taxpayer's children and grandchildren visited the property many times, and would often canoe and fish on a pond located at the property. This was outweighed by other businesslike elements, such as breeding champion quality animals, that proved the taxpayer conducted the activity in a businesslike manner, despite the occasional recreational elements involved.
[John Alan Cohan is a lawyer who has served the horse, livestock and farming industries since l98l. He serves clients in all 50 states, and can be reached at: (3l0) 278-0203 or by e-mail at [email protected]]