by: John Alan Cohan
Attorney at Law

Proper decision making and advance planning are crucial elements in operating a profitable livestock venture. Ever since the inception of income tax, all areas of farming have enjoyed generous tax benefits. Livestock owners are permitted to take depreciation deductions on their farm to offset gross income, as well as to deduct reasonable costs of operating a livestock breeding or activity from other income.

When challenged by the IRS, many a livestock owner has found it to be a daunting handicap in being unprepared. After losing an audit there is the option to go to IRS Appeals and, failing that, to U.S. Tax Court. Louis J. Novak, M.D., of Cleveland, Ohio, a radiation oncologist, ended up taking his case to Tax Court. At stake was over $1 million in losses and $370,000 in depreciation.

The IRS felt that Dr. Novak had no time that he could even devote to the livestock activity because of a heavy work schedule.

Dr. Novak had $269,000 in sales for the years in question. But the judge questioned why some of the commissions Dr. Novak paid to brokers were as high as 50% and even 60% in one instance. Unfortunately, Dr. Novak and his counsel could not rationally explain this. Perhaps the broker was being given a bonus, which is perfectly permissible, but the judge received no explanation to satisfy him.

Also, the judge said that Dr. Novak had not prepared a written analysis to determine how he could make a profit or what he would have to do to break even. Petitioner has not consulted with persons with expertise regarding the financial aspects of his livestock activity.

Thus, the judge held Dr. Novak's activity was not engaged in for profit. Dr. Novak honestly believed that he had the primary purpose and dominant intent of realizing a profit, but apparently the judge disagreed. That meant that Dr. Novak lost his $l million plus in deductions.

The judge felt that Dr. Novak did not perform a detailed analysis of his activity. The judge also felt that some of his actions seemed contrary to a profit objective, such as paying the high rate of commissions on livestock sales instead of the standard commission.

The judge wanted to distinguish between someone being an expert in a field of livestock breeding, and one who is an expert in the economics of the undertaking. A taxpayer's failure to obtain expertise in the economics of [livestock-related] activities indicates a lack of profit motive.

The judge had a hard time figuring out how Dr. Novak had any spare time in which to engage in the livestock activity, given his demanding work schedule at a hospital where he saw patients as well as taught medical classes.

There were other deficiencies in his case. He failed to show that he had bought his farm primarily with appreciation in mind, or that he expected the value of his herd to increase over time. Finally, the judge believed that recreational objectives were a significant component in Dr. Novak's livestock-related activities.

Being a physician or in some other high income profession is a red flag in IRS screening for those who are declaring tax losses in connection with livestock or other farming activities.

It is important to have periodic appraisals of ranch property to show appreciation in value. It is important to have written contracts with ranch managers, and it is equally important to maintain time logs of your own time devoted to ranch activities, specifying what you did and when you did it. In addition, priority should be given to maintaining proper business records and financial projections. If you are audited by the IRS you have many rights and should consult an expert to discuss strategy.

[John Alan Cohan is a lawyer who has served the livestock and farming industry since l98l. He serves clients in all 50 states, and can be reached at: (3l0) 278-0203 or via e-mail at johnalan [email protected], or visit his web site at www.JohnAlan]

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