Originally published on Forbes.com. Aug 4th, 2013
If you engage in a trade or business that loses money, you need to be able to prove that you were really trying to make money, if you want to deduct the losses. Activities that at least superficially appear to have some element of fun about them are inherently suspect. The appeal of anything having to do with caring for large animals escapes me, but then didn’t everybody want to be a cowboy at some point in their upbringing? The owners of JK 3 Star Ranch, LLC had to face this type of scrutiny from the Montana Department of Revenue. The case went to the State Tax Appeal Board. The Montana State Tax Appeal Board seems to be sending the same two word message that the United States Tax Court sends in these cases – Business Plan.
The owners of JK 3 Star Ranch, LLC are Kelly and Jodeen Duryea. They had purchased a 242-acre ranch with a goal of raising Scottish Highlander cattle as a source of retirement income.
The hardness of life in the Scottish Highlands is proverbial. Samuel Johnson made much of it:
Mr. Arthur Lee mentioned some Scotch who had taken possession of a barren part of America, and wondered why they would choose it. Johnson: “Why, Sir, all barrenness is comparative. The Scotch would not know it to be barren.” Boswell: “Come, come, he is flattering the English. you have now been in Scotland, Sir, and say if you did not see meat and drink enough there.” Johnson: “Why yes, Sir; meat and drink enough to give the inhabitants sufficient strength to run away from home.”
That is the attraction, perhaps even the romance, of Scottish Highlander cattle. They take longer to mature, but they apparently are really good at scrounging nourishment from relatively barren land. Montana is not quite as far north as Scotland, but it lacks the tempering effect of the gulf stream, so you can see why these hardy cattle are a good fit for that region.
In 2011, the couple brought in Walter Congdon, an expert, to help them become more profitable. He testified at their hearing:
Mr. Congdon testified that Highland cattle are a hardy breed that matures slowly, compared to typical cattle raised in Montana. The cattle will feed only by grazing, will not eat grain, and take about twice as long to mature for marketing, requiring 30 to 40 months, compared to 22 months for Hereford and Angus steers. The fact that they are not grain-fed makes their meat very popular with specialty restaurants and consumers seeking low-fat meat without grain, who are willing to pay premium prices for the beef.
The stakes were pretty high:
The issue before us is whether or not the cattle-raising operation at the Duryea ranch was a business or a hobby. In treating it as a business, the Duryeas have deducted more than $615,000 against other income over the five years under audit and the annual losses from the ranch more than doubled in that time.
The agent who handled their audit found that they kept good records, but had a serious problem with how thorough their business plan was.
Mr. Ahlers found that the ranch books were well-maintained but that other aspects of the business were lacking. The business plan for the ranch was vague, incomplete, and lacked a marketing strategy, which he considered a significant failing for a business producing a “niche product” like Highland beef. He also pointed out that the Duryeas had not consulted experts or professionals for assistance in the ranching activity during the first five years in question in this case, and the hours spent working on the ranch by the members of the Duryea family, all with full-time jobs outside the ranch.
Although the Tax Appeal Board went through the full nine-factor analysis, it pretty much bought into the agent’s analysis emphasizing things like:
Jodeen Duryea handles the marketing responsibilities for the ranch. She testified that she markets the cattle “basically by word of mouth” to those who are interested. They have also advertised their beef in the Highlander Association newsletter.
(Apparently you can order some here. I understand it is supposed to be pretty tasty.)
The Taxpayers’ own testimony described their decision to raise Highlands as based on a few conversations and Mr. Duryea’s conviction that the longhaired cattle are ideally suited to the cold climate of Montana.
The Board’s finding on the ninth factor struck me as rather odd:
The final element in the test is the degree of personal pleasure or recreation derived from the activity. Taxpayers testified that they did not enjoy raising cattle and did not regard the cattle as “pets.” However, the purpose of the purchase of the ranch was to provide a retirement home for the Duryeas, which is a strong personal enjoyment element not present in most business investments.
Usually, the personal pleasure element is more immediate as opposed to deferred gratification.
Some Practical Tax Planning Observations
I am kind of skeptical that this decision is really right. From my cursory research about the breed, it would seem that you would expect to not be making money for at least quite a few years. What is not clear to me is how much of a federal tax problem, the Duryeas will end up having. In my experience, the states more frequently ride on the federal audits, but the communication does go both ways. This one strikes me as a very close case, so the United States Tax Court might have gone the other way on it, but let’s assume for analytical purposes that this was a federal tax case. Let’s further assume that there will ultimately be a reasonably profitable business. That means that $615,000 of deductions have been blown away. Knowing that ,what could have been done differently ?
A more conservative tax strategy for a side business that has “hobby loss” exposure might be to capitalize as much as possible of your early expenditures. This is a fairly complicated area. There is the election under Code Section 195 and there is the perennial question of whether something is a repair or a capital expenditure. I generally don’t give “audit lottery” advice, but one piece of audit lottery advice that I do give is that a Schedule C or 1065 with lots of expenses and no revenue is very ugly. To the extent you defer expenses, you give up a current cash flow benefit, but you will probably have less exposure if you are deducting them against actual revenue.
The other conclusion I have reached from studying these cases is that documenting the business plan and regularly modifying it are absolutely critical if your endeavor has hobby loss exposure. In many of the cases, I can see that the business plan might be relatively easy to do in one’s head. You can figure out your burn rate and know what the payoff would be if your ship comes in, perhaps in the form of one of your ten horses turning into a first-class stud. Write that stuff down and keep it updated, documenting what you do when things don’t turn out as you planned. It is conceivable that the exercise might actually help you be profitable, but regardless, it is crucial to winning an audit. Remember that revenue agents are trained as accountants, but work for a bureaucracy, not private business. Schedules with numbers on them have much more impact than you telling them stories.
Thoughts On The Beef Business
I can say with confidence that no animals were harmed in the production of this post, but that did not prevent me from becoming a bit disturbed. Pictures of Highlander cattle make me think of them as majestic creatures. Reading about how to do serious business involving them is troubling. Consider this quote from the infallible source:
In order to address this market, Highland beef producers commonly run commercial Highland suckler cows with a ‘terminal’ sire such as a Shorthorn or Limousin bull. This allows the hardy Highland cow, grazed upon the rough hillsides of her natural environment, to produce a cross-bred beef calf featuring the tender beef of its mother on a more modern carcass of high commercial value at slaughter, thus rendering a gross margin from her grazing that would have been impossible from other breeds in that environment.
From a pure business perspective you need to be able to look at the picture of that shaggy brown creature with horns and think “meat machine”.
This is particularly troubling to me since, thanks to my covivant, a vegetarian diet is quite feasible for me. I have developed quite a taste for seitan, which in a well spiced chili, casserole or spaghetti sauce becomes virtually indistinguishable from ground beef. Tofu, on the other hand – well don’t get me started. Seitan’s role as transition protein source for meat lovers is confirmed by the fact that none of CV’s five adult children like it very much. Despite all that, when in a restaurant with various subsets of CV’s brood, I’ll still order meat and, in our refrigerator there is a tightly sealed container of cold cuts, since I just can’t abide cheese sandwiches.
Why People Think The Beef Business Is Fun And An Excess of Sentimentality
The ranch business is suspect as a “hobby loss”, in part, because almost everybody wanted to be a cowboy at some point in their life. Since I just watched it, I can’t help but share with you a final reflection on the allure of the cowboy life, which was probably pretty miserable in reality. This clip is not from a cowboy movie. Rather it is from the greatest bromance ever made:
I think baseball player came after cowboy in terms of my boyhood career choices. The sentimentality is getting to be too much. Next thing you know, I’ll be telling you about a 12-year-old boy in a box seat in Shea Stadium watching Jim Bunning pitch a perfect game. The senior order clerk sitting next to the boy had probably scored the tickets from a client who happened to get particularly good execution in a then much less efficient stock market. The senior order clerk had just over a year left to live. The game was on Father’s Day.
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