In hobby loss audits, the IRS sometimes views various types of ranching activities as a means of generating tax losses, rather than a profit-oriented venture. That was the issue in the Tax Court case, Ralph Wesinger, Jr., v. Commissioner of Internal Revenue [T.C. Memo 1999-372].
Mr. Wesinger owned a lucrative computer servicing business in San Jose, California. He purchased two parcels of unimproved land and started a cattle ranch. He had some experience helping out occasionally on two dairy farms near where he grew up.
He did not seek any professional assistance at the time he purchased the ranch as to its suitability for cattle ranching. He had no formal business plan detailing how a profit was to be made from the ranching operations. His plan was to buy, raise and sell cows. However, he learned that the grasses on the land would not support the cattle.
He made improvements, including fencing and a well, and made plans to grow alfalfa and wheat.
He obtained a soil conservation report, and a field inventory report. He was advised that no more than 17 animals could be grazed with the land in its current condition. He made some irrigation improvements. He tried to graze 23 head, but did not put them into service until six years after he acquired the land.
Mr. Wesinger did not live on the ranch, but visited it 15 to 17 times per year for 3 or 4 days at a time. He kept no separate books and records for his ranching operations, but he kept checks and receipts relating to the ranch in a separate file on his personal computer. He also sought to take tax deductions on an aircraft for business purposes.
In a lengthy opinion the court held that the ranch losses were not deductible because they were for an activity carried on primarily as a sport, hobby, and for recreation.
First, with respect to books and records, the court said that Mr. Wesinger had only minimal records that were short of what has been identified by courts as signaling a bona fide intent to carry on a business. There were no records of cost accounting or analysis that could help him evaluate the overall performance of the operation.
The court said: “It seems unlikely that entrepreneurs seriously intending to profit from a ranching venture would allow land allegedly purchased for that purpose to sit unused for 6 years before first placing cattle on the property.”
The court said that Mr. Wesinger failed to make attempts to improve the profitability by changing methods and techniques.
The court noted that there was no formal business plan, and not even an informal “plan for success.” The court faulted the taxpayer for not conducting a basic investigation of the factors that would affect profit, that he had little preparation with regard to the economic aspects of the venture, and that, despite his business background, he failed to investigate the field before embarking on it, or consult with experts on the business end of the activity.
The court also noted that he went to the ranch only 15 to 17 times a year for brief visits, and that he did not hire anyone to run the ranching in his absence.
The court also noted that Mr. Wesinger's ranch had extensive losses in each year of operations.
The court also disallowed deductions for the aircraft usage, and went into detail on that point. The opinion is quite long and well worth reading.
The lessons to be learned from this and similar cases for people in the livestock and other farming industries is that it is important to have advance and ongoing planning, not only with a view towards profitability, but to provide documentary evidence proving that it is your intention to make a profit, even if profits are not forthcoming.
Some type of written business plan is important to have in case you are audited. The IRS Audit Manual says: “The taxpayer should have a formal written plan. This plan should demonstrate the taxpayer's financial and economic forecast for the activity. The 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.” Auditors are asked to be on alert for “scanned” business plan documents. They are further advised to “consult with local Agricultural Cooperative Extension Agents in order to obtain qualitative formulas to scrutinize the figures projected on the business plan.”
Livestock and other farming ventures should be operated basically in the same way as other businesses, utilizing business principles and judgment in decision-making, and maintaining appropriate books and records. Consulting with experts as to how to make a profit is also something that is important. Many people decide that obtaining a tax opinion letter from an attorney, with a view towards analyzing their venture and making the venture conform as best as possible to IRS guidelines, is an excellent way to be prepared in case of an audit.
[John Alan Cohan is a lawyer who has served the livestock, farming and horse industries since l98l. He serves clients in all 50 states, and can be reached at: (3l0) 278-0203 or by email at [email protected]]