Many people who own livestock farms are full-time professionals in non-farming fields. But another large segment of ranching consists of retired individuals who wish to supplement their retirement income with profits from ranching, farming or raising horses. The IRS often enough will assess deficiencies against these individuals based on the idea that the activity is simply a means of generating tax write-offs. An example of this was the case of Garbini v. Commissioner, T.C. Summary Opinion 2004-7. This involved the issue of whether the taxpayers were engaged in an activity for profit in connection with a cattle and horse breeding operation in Myrtle Creek, Ore.
Mr. Garbini listed his occupation as a rancher, and his wife indicated she was a housewife. Both taxpayers were senior citizens during the two taxable years in issue, and for Mr. Garbini this was a full time venture. They had a net loss of $127,341 in one year, and $124,584 for a second year at issue. The court examined whether they carried on the activity with the actual and honest objective of making a profit. Although a reasonable expectation of profit is not required, the facts and circumstances must indicate that the taxpayer entered into the activity, or continued the activity, with the actual and honest objective of making a profit.
The objective of making a profit must be analyzed by looking at all the surrounding facts. In applying the factors of the IRS hobby loss regulations to determine profit objective, the court focused on the manner in which they operated the ranch. The taxpayers in this case did not seek expert advice before entering the activity. They had no tax opinion letter to prove that their activity originated with the honest objective of making a profit. The taxpayers did not maintain very much by way of books and records. Rather, Mr. Garbini made a monthly list of expense categories and, based on his canceled checks, recorded the amounts expended for each category. The court said that he did not keep the type of records which could be used to increase the profitability of a business. He never prepared budgets or market projections which would outline strategies for ensuring a profitable business venture. The court said that his record keeping practice was inadequate and not indicative of a prudent and reasonable person in business.
Mr. Garbini said that he made efforts to reduce expenses in order to operate the ranch in a profitable manner. Nothing in the record indicated what efforts he actually made to reduce expenses.
This is an important point: Taxpayers should have documentary evidence to show what they did to enhance the profitability of the venture. Mr. Garbini never ascertained how or when he would make a profit or how he could change his operating methods to improve his profitability. Mr. Garbini worked on the ranch almost every day and employed one full-time ranch hand, who performed general maintenance of the property and barns. Mr. Garbini occasionally hired outside temporary labor.
Perhaps the most important fact against the taxpayer was that there were no sales of cattle. The strong point in favor of the taxpayers in this case was that the ranch had increased in value as a result of improvements made by the taxpayers. Mr. Garbini testified that he bought the property for $566,000 in its undeveloped condition, and its value at the time of trial was $15 million. However, Mr. Garbini did not provide any evidence for this estimate. In order to prove this, a taxpayer needs to have an expert prepare a report to show details pertaining to the appreciation in value, but in this case all the court had was the taxpayer's testimony. Mr. Garbini also argued that part of the ranch activity involved planting and harvesting trees. He stated that he had planted 3,000 to 5,000 trees per year, and that they are suitable for harvesting after seven years. However, the court noted that no trees were harvested during the taxable years in issue. The court also considered the history of income or losses. Over a time frame of 12 years, Mr. and Mrs. Garbini incurred losses of about $1,500,000. There apparently was no evidence of any profits in any year. The court considered the financial status of the taxpayer. The taxpayer and his wife earned income from interest and dividends on a mobile home park they had developed. The court noted that as a result of their other income, the taxpayers realized substantial tax benefits from the approximate $125,000 loss deduction for each taxable year in issue. The court also said that there were elements of personal pleasure or recreation. The court said that the taxpayers probably had personal pleasure from residing on a large ranch. If there is a significant history of losses in operating a ranch or farm, it is important to keep recreational elements to a minimum so as to not suggest that is your primary purpose. For example, if you maintain horses on the farm that you ride for pleasure, it is important to not take tax deductions in connection with their costs.
Taking the record as a whole, the court concluded that Mr. and Mrs. Garbini did not possess the actual and honest objective of making a profit from their ranch. According to other recent Tax Court cases, one of the most important elements in withstanding IRS scrutiny is to have some type of plan – a business plan – in which you set forth in writing how and when you expect to make a profit from the venture. It is important to have a separate checking account for farm expenditures, and to maintain a ledger of transactions.
John Alan Cohan is a lawyer who has served the farming, livestock and horse industries since 1981.
