Just about every business starts out with losses. This is the nature of start-ups. The activity will either gain traction and produce income and possibly a profit or, eventually, the activity end.
This is basic economics and capitalism at work. The U.S. economy is based on these concepts, allowing would-be entrepreneurs the opportunity and motive to convert activities to those that produce economic benefits.
It is often thought that the benefits not only benefit the entrepreneur, but also the economy as a whole. Profitable activities shine a light on other opportunities to make activities into profit making ventures. Synergies lead to additional growth. Industries are created. Money circulates. The economy grows.
But where do taxes fit into this? Start-ups produce tax losses. The losses usually offset income from some other profit making activity or store of wealth. Thus, taxpayers partially subsidize start-ups as taxes that would be paid on other activities are not paid given the tax losses incurred for start-ups.
Our tax laws have various start-up, hobby, and trade or business concepts that say how much of a subsidy we as a society are willing to provide. The line is anything but bright. It is better described as a line written in chalk partially eroded by heavy foot traffic.
The Whatley v. Commissioner, T.C. Memo. 2021-11, case provides an opportunity to consider these rules. It involves an activity that could and might have grown into a business, but the IRS just happened to audit and examine the business during its start-up phase.
Facts & Procedural History
The taxpayer worked in the banking industry. Once retired, he founded his own bank. He spent 70 hours a week working for his bank, which is no doubt why the bank grew over the next ten years. Hard work is usually the secret to success.
Prior to founding the bank, he had purchased land in Alabama. The property was wooded. The taxpayer spent approx. 700 hours a year performing maintenance on the property.
The property produced losses from 2004-2008. These losses were reported on a Schedule F, Profit and Loss From Farming. The losses consisted primarily of depreciation deductions for two building structures located on the property.
The IRS audited the taxpayer’s returns and determined that the farming losses were not allowable. Tax litigation ensued.
The U.S. Tax Court was asked to decide whether the farm amounted to a trade or business for which tax deductions were allowable.
Trade or Business
To be deductible, an expense generally has to be an ordinary and necessary business expense under Sec. 162 or an investment expense under Sec. 212.
The Tax Cuts and Jobs Act curtailed most expenses under Sec. 212, as it eliminated the ability to take most miscellaneous itemized deductions. The expenses for Sec. 212 activities are miscellaneous itemized deductions. This shifts the focus to Sec. 162. Taxpayers need to argue that they have a trade or business.
Taxpayers can also rely on Sec. 183 to deduct expenses that do not qualify under Sec. 162. Sec. 183 allows expenses that are not otherwise deductible if the taxpayer can show that the expense was incurred in an activity “engaged in for a profit.” Activities that do not meet this standard are often commonly referred to as “hobby losses.” These rules generally apply on a stand-alone basis, but there are grouping rules that can help if taxpayers can combine two or more activities as one business.
About Hobby Losses
The regulations set out a nine-factor test to consider whether an activity is engaged in for a profit. The court summarizes the factors as follows:
- the manner in which the taxpayer carries on the activity;
- his own expertise or that of his advisers;
- the time and effort he expends on the activity;
- the expectation that assets used in the activity may appreciate in value;
- his success in carrying on similar activities;
- his history of income or losses with respect to the activity;
- the amount of occasional profits, if any, from the activity;
- his financial status; and
- any elements of personal pleasure or recreation.
The U.S. Tax Court had this to say about the nine factor test:
The Seventh Circuit has called this open-ended test of objective factors of subjective intent “goofy” and has chosen not to “wad[e] through the nine factors,” but instead to take a more holistic approach. Roberts v. Commissioner, 820 F.3d 247, 250, 254 (7th Cir. 2016), rev’g T.C. Memo. 2014-74. This case, though, is appealable to the Eleventh Circuit. So we’ll trudge along the well-blazed trail and address each specific factor, as well as any other additional facts we find important to determine if Whatley was engaged in farming for profit.
The Roberts case is an interesting read. It is a case where Judge Posner suggests that the U.S. Tax Court’s ruling was “untenable.” In that case, the U.S. Tax Court had determined that the taxpayer purchased property to operate a business, but that it was not operated for a profit for the first two years until it was actually used for the business. The appeals court took issue with start-up expenses being denied as hobby loss expenses.
The Seventh Circuit had this advice for the U.S. Tax Court:
Considering that most commercial enterprises are not hobbies, the Tax Court would be better off if rather than wading through the nine factors it said simply that a business that is in an industry known to attract hobbyists (and horse racing is that business par excellence), and that loses large sums of money year after year that the owner of the business deducts from a very large income that he derives from other (and genuine) businesses or from trusts or other conventional sources of income, is presumptively a hobby, though before deciding for sure the court must listen to the owner’s protestations of business motive. For an analysis along these lines see our decision in Estate of Stuller v. United States, 811 F.3d 890, 896-98 (7th Cir.2016).
This would be an easier way to analyze hobby-loss cases, but to do so the tax court would have to ignore the factors set out in the regulation. Taxpayers are entitled to rely on the regulations as they carry the full force of law.
Start-Up or Hobby?
Back to this case, the U.S. Tax Court essentially found that all of the nine factors favored the IRS’s position. What it doesn’t really do is explain the tie-in with the Roberts case the court cited.
The facts, in this case, suggest that the taxpayer was taking steps to transform the farm from a startup into a business. The court’s opinion notes:
As to the farm’s cattle operation, Whatley explained that he’d wanted to introduce cattle “from day one.” Whatley testified that he consulted two cattle experts for advice, but those men managed much larger herds—600 and 1,500 head respectively—than what Whatley could reasonably expect to put on his property. Whatley, however, could not recall when this consultation took place or what advice he received. In any event, he didn’t actually have cattle on his property until at least 2008, right after he learned that the IRS was going to audit him. And he explained that many of the activities that he reported as related to cattle were really activities that he undertook in preparation for cattle that would arrive sometime in the future. These included the installation of some fencing and repairs to the barn.
There are other similar references in the court opinion suggesting that the activity was a start-up. The references suggest that these activities are tied to the start of the IRS audit.
Even if the activities were tied to the start of the IRS audit or if that was a coincidence, the facts still suggest that the end goal was a business.
If the taxpayer appeals the case, it will be interesting to see what the appeals court does with the case. Does the court adopt an approach similar to the Seventh Circuit in Roberts and take a longer look at the activity to see that it is a start-up that is about to convert into a business? Or will the court conclude that only the years under audit are to be considered and during those years, the business was a hobby rather than a start-up in process?