Generally, a taxpayer can deduct all ordinary and necessary expenses paid or incurred to carry on a valid trade or business, even if this would create an overall loss on the income tax return. However, if the taxpayer’s activity is considered a hobby, rather than a business, deductions are limited to the gross income earned from the activity. So how can you tell if your loss is from a hobby or a business?
Stephen Whatley learned this lesson the hard way. Whatley worked on his family’s farm growing up and briefly operated a timber-harvesting operation in his twenties. However, most of his adult life (over 43 years) was spent in banking. He even founded his own successful bank where he remains chairman, president and CEO.
In 2003 and 2004, Whatley purchased 182 acres of land near his hometown. He intended to harvest the timber on the land (in the 2020s) and wanted to introduce cattle but didn’t take substantial steps towards this goal until after his return had been selected for audit in 2008. After the audit began, Whatley obtained a forest-management plan and purchased cattle. From 2004-2014, the returns reported losses of over $1.5 million.
The Tax Court applied the nine factors in Treasury Regulation 1.183-2(a) to Whatley’s situation and found that his cattle ranch was a hobby, not a business.
- The manner in which the taxpayer carries on the activity. Whatley only kept limited business records, had no business plan and never turned a profit in any single year. This factor weighed against him.
- The taxpayer’s expertise or that of his advisers. While Whatley came from a long line of farmers, his expertise was in banking, with the exception of one short foray into timber-harvesting over 35 years prior. This factor weighed against him.
- The time and effort the taxpayer expends on the activity. Whatley spent significant time in his banking operations (estimated at 70 hours per week). He did not hire anyone to operate his farm. This factor weighed against him.
- The expectation that assets used in the activity may appreciate in value. The court noted “[a] big part of Whatley’s problem here is that [farm] was so spectacularly unprofitable.” Even when it was first audited, overall losses already exceeded the projected highest value of the timber many years in the future. This factor weighed against him.
- The taxpayer’s similar success in carrying on similar activities. The court recognized that Whatley had an entrepreneurial spirit, though no direct success in a similar activity. This factor was considered neutral.
- The taxpayer’s history of income or losses with respect to the activity. The farm produced losses every year and these losses were not the result of unforeseen circumstances. This factor weighted against him.
- The amount of occasional profits, if any, from the activity. Again, the substantial losses over the years weighed against him.
- The taxpayer’s financial status. Whatley had substantial income from banking but only losses from farming. This factor weighted against him.
- Any elements of personal pleasure or recreation. The farmland was near Whatley’s hometown and he enjoyed going there as a retreat from his strenuous banking career. This factor weighs against him.
In the Tax Court’s words “[a] cattle farm without cattle and a tree farm that doesn’t harvest timber is highly likely to produce a bumper crop of losses.” His losses were denied. If you have any questions about whether your activity is a business or a hobby, please consult your Henry+Horne advisor.
Jennifer King, CPA