The poster child for IRS attacks on hobby losses is probably the horse breeding business. I don’t exactly live in horse country, so most of what I have learned about the business has been from reading Tax Court decisions. There is a serious sampling problem in making inferences from that material, but nonetheless I have made them. My inferences are that it is very hard to make money in that business, it only seems like it is fun if you don’t think about it too much and there is a lot that can go wrong. My limited actual experience in 30 years of general tax practice has not contradicted those inferences. Nonetheless, horse breeders do pretty well in Tax Court when challenged under Section 183 (hobby loss) – a lot better than]Amway IBOs for example.
Twin River Farms, Inc was an S Corporation. You cannot tell from the decision whether it was passing income or losses through to its sole shareholder, Diane Militana. That was not the issue. Ms. Militana testified that she had been involved in two other audits of similar businesses that operated the same way and the issue had never been raised. The IRS was not seeking to deny Twin Rivers deductions for amounts paid to Adam Lopez Morales and Nallhelyo Ruiz. The IRS was maintaining that Twin Rivers should have been treating them as employees. It reminds me of the Everglades one of my favorite Kingston Trio songs:
“… better keep a movin and don’t stand still. If the skeeters don’t get him, then the gators will.”
In my imagination, the auditor is presented with a magnificent business plan showing how Twin River will ultimately prosper, even if it is not doing so well right now and detailed substantiation of expenses. The auditor gets into a discussion of what these payments to Morales and Ruiz are all about and learns:
During the years at issue the workers’ job duties included: cleaning stalls, the barn area, the barn offices, the rest room, and the tack room; grooming horses; watering the horses; and moving the horses between pastures. The harnesses, brushes and combs, shovels, pitchforks, wheelbarrow, manure spreader, and brooms used to care for the horses and barn were all owned by petitioner .
During the years at issue Mr. Morales was also primarily responsible for cutting grass in the pastures and otherwise performing grounds-keeping-related activities. Mr. Morales used weed whackers, a Bush Hog mower, a tractor, and other equipment provided to him by petitioner to cut the grass in the pasture.
On occasion the workers also repaired fences on the property. The materials to maintain the fences were provided by either petitioner directly, or Mr. Morales would pick them up at the store, sign for the materials, and have the bill sent to petitioner.
Petitioner paid to each worker weekly compensation by check signed by Diana Militana in her capacity as president. Mr. Morales was paid $300 per week, and Mr. Ruiz was paid $150 per week. The workers were sometimes given advances on their weekly compensation. When a worker received an advance on his weekly compensation, his next several compensation checks were reduced to repay petitioner for the advanced amount.
Well that all sure seems like ordinary and necessary business deduction deductible under Code Section 162. Another easy audit? Not so fast:
With respect to the years at issue petitioner did not file with respondent any Forms 943, Employer’s Annual Federal Tax Return for Agricultural Employees, or Forms 941, Employer’s Quarterly Federal Tax Return. For the years at issue petitioner did not make deposits of employment tax with respondent and has not paid any of the employment tax liability that was determined in the notice. For the years at issue petitioner did not file Forms 1099 with respect to the workers.
Oops. It amounted to about $30,000 in tax and penalty.
Whether someone is an employee or an independent contractor is a question of facts and circumstances. Basically this case has almost nothing that leans in favor of independent contractor status. I am citing it more as a cautionary tale for people who think they are all set for an income tax audit and get blindsided from another direction. Many of the IRS audit manuals for different industries emphasize the employer independent contractor issue which can sometimes create a larger deficiency than simply disallowing deductions. There is a twenty-factor analysis on the employee independent contractor issue. Here is a link to a discussion of it. I will give you my abbreviated rule of thumb. If you are asking the question, the person is probably an employee.
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Originally published on Forbes.com on July 6th, 2012