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Originally published on Forbes.com. Aug 15th, 2014

The recent Tax Court decision in the case of Raymond and Sherry Gardner evokes nostalgia for the heyday of tax shelters.  Cattle leasing was one of the classic go-to industries for tax sheltering. Joe Kristan commenting on a post by Paul Neiffer wrote:

This is almost quaint.  When I first started working in the 1980s, I saw a few shelters like this.  A cow worth, say, $2,000 would be sold for $50,000, $2,000 down and the rest on a “note” that would never be collected — but the “farmer” would depreciate $50,000, rather than $2,000.  I’m a little surprised it is still going on, considering the at-risk rules, passive loss rules, and hobby loss rules against this sort of thing.

Much of the complexity in our income tax system is collateral damage from the war against tax shelters Advocates for the Fair Tax talk about a great era of simplicity and the abolition of the IRS when we adopt their system. How simple will the Fair Tax look after a few years of gaming a system that requires adding 30% to the price of just about every good and service you consume? Nonetheless, the war against tax shelters added one set of rules after another.  The silver bullet was supposed to be the passive activity loss rules in the Tax Reform Act of 1986.  This followed the stiletto of the “at-risk” rules, whose legislative history I am not inclined to ferret out right now.

Interestingly, in attacking Mr. Gardner’s cattle activity, the IRS passed over both the silver bullet and the stiletto to go for the blunt instrument – Section 183.  Section 183 is sometimes called the “hobby loss section”, but its application is much broader.  Basically, if you post losses from an activity in which you are not trying to make a profit you can be denied those losses under Section 183.  It is much worse than having the losses deferred under the passive activity loss rules.  It may turn out to be even much, much worse than having the losses suspended under the at-risk rules, but we will save that for the end.

Section 183 was part of the Tax Reform Act of 1969.  I was in high school then, technically living in poverty, although it was not at all bad, so I kind of wasn’t paying attention to tax legislation.  I didn’t make it to Woodstock, but I did hear about it.

What Is An Activity Not Engaged In For Profit?

The Court looks at nine factors to determine whether an activity is engaged in for profit.  Here is how it went for Mr. Gardner.

Manner in Which the Taxpayer Carries On the Activity 

This factor had the longest discussion and at the end of it you could be pretty sure things were not going to go well for the taxpayer.  Here are the highlights.  (Note that in Tax Court cases the taxpayer is always the “petitioner” and the IRS the “respondent”.)

Most of the deductions for expenses associated with petitioner’s cattle operation appear to have been financed by promissory notes that petitioner signed. Petitioner entered into 24 promissory notes with a total principal of $1,065,325. Each of the notes had a stated interest rate. Petitioner did not pay interest on any of the 24 notes.

Petitioner pledged his cattle as collateral in each of the promissory notes. Petitioner’s manner of paying the notes is not indicative of a taxpayer who is concerned about protecting the primary assets of his business.

Petitioner’s original goal in the alleged cattle operation, as stated in his business plans, was to develop and sell genetically superior cattle. In an expert witness report for respondent, Mr. Daily noted that cattle with documented genetics that are registered with breed associations generally sell for a higher price than cattle that are not genetically documented. The report stated:

In order to genetically engineer a herd, it is necessary to track genetics through the use of records. Mr. Gardner has failed to maintain any records relating to the genetic makeup of the herd I viewed. *** The cattle I viewed are not registered and have no production data. Therefore, they can only be valued as common commercial cows. 

Petitioner received from David Pearl income and expense summaries on an annual basis. This was the only financial information that petitioner received regarding the results of his cattle operation. Petitioner reported net losses from his cattle operation of $100,010 for 2001, $36,097 for 2002, $29,875 for 2003, and $614,747 for 2004. Petitioner allegedly was losing a substantial amount of money, yet he did not receive financial information on a basis that was more current than once a year. Receiving financial information on an annual basis, in the light of the fact that petitioner incurred substantial losses, indicates that petitioner did not conduct the cattle operation in a businesslike manner

Tax Court judges love business plans.  Apparently Mr. Gardner had a couple.  Unfortunately, it does not appear that he followed any of them.

All in, things were not carried on in a businesslike manner.

Expertise

If the only expert you consult has an interest in you doing the deal, that does not count. Amway IBOs who only listen to their “upline” have a similar problem.

David Pearl testified that he received a bachelor’s degree in animal science from Purdue University. David Pearl has operated his family farm for decades and had worked with Purdue University. Petitioner claims to have relied on the advice of David Pearl. However, David Pearl was not an independent adviser to petitioner. Instead, petitioner’s cattle operation transacted almost exclusively with entities controlled by David Pearl. As a result, petitioner’s reliance on advice from a person with whom he exclusively transacted is not indicative of a profit motive.

Time And Effort

The Court concluded that Mr. Gardner, who had not substantiated the time he spent on the cattle operation, had too much else going on to spend much time with the cattle.

 Expectation That Assets Used in Activity May Appreciate in Value 

Mr. Daily concluded in his expert report that the fair market value of petitioner’s cattle was $193,325. Petitioner entered into 24 promissory notes with a total principal of $1,065,325. For the taxable years 2001 through 2010, petitioner reported $798,671 of net losses for the taxable years 2001, 2002, 2003, 2004, 2008, and 2010, and $176,994 of net income for the taxable years 2005, 2006, 2007, and 2009. As a result, petitioner’s cattle operation had an overall loss of $621,677 for the taxable years 2001 through 2010. The amount of petitioner’s overall loss is more than three times the amount of the fair market value of his cattle. Furthermore, petitioner owes a substantial amount of debt on the promissory notes.

Success of the Taxpayer in Carrying On Other Similar or Dissimilar Activities

This factor was a push.

 Taxpayer’s History of Income or Losses With Respect to the Activity

Despite substantial losses on net, the Court also found this factor neutral.

We note that petitioner’s net losses ballooned from $36,097 and $29,875 in 2002 and 2003, respectively, to $614,747 in 2004. At the same time, petitioner’s income from his insurance business also ballooned from $152,373 and $163,305 in 2002 and 2003, respectively, to $579,236 in 2004. We also note that in regard to the four entities in which petitioner had ownership interests, he reported total losses of $30,116 and $37,020 for the taxable years 2002 and 2003 and total income of $80,318 for the taxable year 2004. Due to the manner in which petitioner conducted his cattle operation, we take a critical view of the coinciding of the substantial increase in petitioner’s net loss from his cattle operation in the same year that the income from his insurance business and other ownership interests also substantially increased.

We note that petitioner reported $780,729 of net losses for the taxable years 2001 through 2004. The 2005 tax year was the first year that petitioner reported a net income from his cattle operation. 33 Coincidentally, the IRS began an examination of petitioner’s cattle operation during 2005. The initial appearance of a profit in the taxable year in which the IRS commenced an examination is conspicuous

 The Amount of Occasional Profits, If Any, Which Are Earned

The net losses were much too high.  IRS won on this.

Financial Status of the Taxpayer

Since cattle losses were offsetting substantial income, the taxpayer lost on this factor.

Elements of Personal Pleasure or Recreation

This is often an issue with ranches, but not in this case.  The Tax Court was convinced that Mr. Gardner was not having fun working with the cows.  This is the only factor in his favor.

And The Taxpayer Loses

Although it is not a purely mechanical test, six of the nine factors went to the IRS, making Mr. Gardner liable for over $300,000 in tax and penalties for the years 2002, 2003, and 2004.

Why This Is Worse Than The Other Ways To Lose

Mr. Gardner had over $1,000,000 of indebtedness and presumably negligible basis in his cows.  That means that there might be a big gain down the road.  If losses had been suspended under the at-risk rules or passive activity loss rules, they would be allowed when that gain is recognized.  Section 183 just blows the losses away.  So this whole enterprise may end up turning into the reverse of a tax shelter.

Tax advisers should probably be more sensitive to their client’s exposure under Section 183 when they see year after year of persistent losses. If the client insists that the side activities will be ultimately profitable, it might be wise to consider whether it would be better to suspend the losses. Even if the ultimate denouement is a large loss, it will not be those ugly year to year losses. Not that I am one to give audit lottery advice. Just saying.