This came to me in the daily updates from CCH.  I thought some here might find the discussion pertinent, since in the last few months several have broached the "hobby farm" topic.  This is a Tax Court decision.......and therefore the IRS is NOT required to follow its decision in other situations.

Note the emphasis on "doing one's homework, and documenting it". Even notes, or printouts of internet discussions, would have helped the taxpayer.  The use of promissory notes is not a pertinent issue---- any Newbie should have been able to cover that problem---- but the fact the parties claimed deductions without the proper methodology behind them is the noteworthy concept.

This "hobby farming", or "passive activity" problem, is not only applicable to farming, but to any type of business.  Example--- your brother has a repair shop, in which you are a 50% "silent partner".  You also are a very busy farmer. If that partnership should show a loss, and you want your share to offset other active business interests--- say, farming---- then a document trail will need to be existing to show that you were involved more than the required time per the Code..... otherwise the loss is deductible only against passive activities gains.

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CCH Federal Tax Day - Current,J.1,Individual Could Not Deduct Expenses of Cattle Breeding Hobby; Penalties Applied (Gardner, TCM),(Jul. 29, 2014)

An individuals’ cattle breeding program was not a for-profit business; therefore, the expenses allegedly paid by the taxpayer in connection with that program were not deductible as business expenses. The taxpayer transacted with another individual and various businesses owned by that individual (the breeder) to breed genetically superior cattle to be sold as seed stock and to commercial beef markets. However, the taxpayer and the breeder failed to keep adequate records on the cattle, which were, therefore, valued as common commercial cattle. The taxpayer did not provide evidence showing the amount of time he spent on the cattle business. Most of the deductions for expenses associated with the cattle operation were purportedly financed by promissory notes from the taxpayer to the breeder, but few payments were made on these notes, and no interest was paid.

The court analyzed the factors listed in Reg. §1.183-2(b) and found that factors favoring the IRS included:

(1) The evidence did not support the taxpayer’s claim to have made significant payments on promissory notes held by the breeder. The taxpayer paid no interest and little principle, and was in default on most of the notes most of the time. The taxpayer’s failure to enforce a number of contracts, to show interest in financial information, to make and adhere to business plans, and to maintain adequate records indicated that he were not conducting the cattle operation in a businesslike manner.

(2) The taxpayer failed to offer documentary evidence of his decades-long research effort allegedly undertaken in preparation for the cattle operation. He did not show that he was knowledgeable with respect to the cattle industry. The only person the taxpayer was shown to have consulted was the breeder with whom he transacted, who was not an independent adviser.

(3) The amount of time the taxpayer purportedly spent on the cattle operation was not substantiated. He was engaged in numerous other business activities during the years at issue.

(4) The cattle operation had an overall loss of more than three times the fair market value of the cattle, and the taxpayer owed a substantial debt on the unpaid promissory notes. The taxpayer did not have a justifiable expectation that the assets used in the cattle operation would appreciate.

(5) The losses from the cattle operation were used to offset the taxpayer’s substantial income from other businesses and commercial ventures.

Two other factors were neutral and one favored the taxpayer.

The taxpayer was liable for accuracy-related penalties for the years at issue. The understatement for each year exceeded the greater of 10 percent of the tax required to be shown on the return or $5,000, which constituted a substantial understatement. The taxpayer did not act with reasonable cause and good faith. The information given to his accountant to prepare returns was compiled by the breeder, who was not a competent professional with respect to accounting or tax law. Further, the taxpayer failed to provide necessary and accurate information to his accountant, such as claims that interest was paid on debts when no interest was paid. Additionally, the Internal Revenue Code did not provide "substantial authority" for the claimed deductions, in light of the facts of the case. Finally, the taxpayer did not adequately disclose all facts to the IRS and never filed a disclosure statement (Forms 8275 and 8275-R) with his returns.

R.E. Gardner, TC Memo. 2014-148, Dec. 59,974(M)

Other References:

• Code Sec. 183

• CCH Reference - 2014FED ¶12,177.177

• CCH Reference - 2014FED ¶12,177.243

• Code Sec. 6662

• CCH Reference - 2014FED ¶39,652.34

• CCH Reference - 2014FED ¶39,652.41

• Code Sec. 6664

• CCH Reference - 2014FED ¶39,661.654

• Tax Research Consultant

  • CCH Reference – TRC BUSEXP: 15,050CCH Reference – TRC PENALTY: 3,108.15