Appreciation and strong manager win cattle hobby loss case

First Tax Court Hobby Loss Opinion of the year is a taxpayer victory. Paul and Patricia Wondries faced deficiencies totaling $421,503 for the years 2015-2017. At issue was whether his 1,100-acre ranch was being run for profit. Judge Kathleen Kerrigan ruled it a closed case, but concluded that the petitioners had engaged in ranching and that the activity was not a hobby. The opinion gives us a good look at the nine factors used to evaluate hobby loss claims. There’s also something a little worrisome about the decision.

The facts

This is Judge Kerrigan’s opinion of what happened. Mr. Wondries is a very savvy businessman who has operated many successful business ventures. Among them were 23 car dealerships, half of which managed to convert from losing businesses to profitable ones. In 2004, the couple decided to diversify their business interests by purchasing a cattle ranch in Parkfield, CA.

The Wondries used bank financing to acquire the 1,100 acre ranch in Parkfield CA complete with main house, guest house, pool and foreman’s house. The business plan submitted to the bank projected loan payments from cattle sales and guided hunting expeditions. The property cost $2 million, one million below the listing price.

They hired an experienced ranch manager. They quickly determined that raising cattle was a challenge due to high feed prices. There was also a drought that complicated things. The Wondries sold most of the cattle. They also determined that guided hunting was not feasible as the ranch was too small to accommodate enough wild animals and the liability risk and insurance requirements.

So the business plan seems to have become an improvement approach to appreciation. The Wondries were able to hold out since their other income was quite substantial. According to the decision, his total income between 2015 and 2017 exceeded $32 million.

Judge Kerrigan framed the question as “whether the applicants went into the ranching business for profit, and therefore whether the deduction was appropriate.” Given that framework, it looks like there must have been some cattle left over after they sold most of it.

The facts

Judge Kerrigan paraded through the nine factors

(1) the manner in which the taxpayer carries out the activity; (2) the experience of the taxpayer or the taxpayer’s advisers; (3) the time and effort used by the taxpayer in the development of the activity; (4) the expectation that the assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying out other similar activities; (6) the taxpayer’s history of income or loss with respect to the activity; (7) the amount of occasional earnings, if any, obtained; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved.

The taxpayers gained by going business-like: keeping accurate books and records, hiring a competent manager, changing the original business plan when it proved unfeasible. like me have noticed countless times my case study shows that if you win on the first factor, you win. Otherwise you lose.

Taxpayers also gained from the second factor experience of the taxpayer or adviser, drawing heavily on the ranch manager’s experience.

Taxpayers also gained on the third factor of time and effort. This was pretty weird because they didn’t spend a lot of time, but Judge Kerrigan pointed out that they had the ranch manager there, so it didn’t matter. I am surprised that this factor should have been neutral, but there are many good reasons why I am not a Tax Court judge.

The fourth factor, the expectation of appreciation, seems to be really critical.

During each year in question, the ranch averaged approximately $300,000 in losses. Assuming this trend continues, the petitioners could still expect to make a profit even if we assume the property sells at the lower end of the petitioner’s husband’s estimates. The margin by which they make a profit is decreasing every year. Since a profit can still be made, we find this factor weighs in favor of petitioners.

Contributors also gain from success in other activities even if they are different.

Factors six, seven, and eight are essentially freebies to the IRS. There were losses and losses and losses and the Wondries made a lot of money elsewhere.

Judge Kerrigan also credits taxpayer testimony that there was not much, if any, in the way of recreation involved in giving them the factor of nine.

The dog that didn’t bark

I was very disappointed that there was no activity discussion in the case. Assuming some ranching still existed, Regulation 1.183-1(d) holds that ranching and appreciation property ownership cannot be considered a single activity unless ranching reduces the cost of maintaining the land.

Where land is purchased or held primarily with the intention of benefiting from its increased value, and the taxpayer also engages in agriculture on such land, agriculture and land tenure will normally be considered a single activity only if the Farming activity reduces the net cost of bringing the land to its appreciation in value. Thus, agricultural exploitation and land tenure will be considered a single activity only if the income derived from exploitation exceeds the deductions attributable to agricultural activity that are not directly attributable to land tenure (that is, different deductions). directly attributable to ownership of the land, such as interest on a mortgage secured by the land, annual property taxes attributable to the land and improvements, and depreciation on improvements to the land).

Holding land for long-term appreciation is generally not itself a trade or business, which could have changed the character of some of the expenses.

Another card for your deck

I find this opinion disconcerting, but as someone who represents taxpayers, I like it. Lew Taishoff covering it anticipated that. In Good help is hard to findhe writes:

But Mr. Palm, the manager, saves the day. Mr. Palm had a great track record running cattle ranches, and Paul kept enough records and supervision to show that he meant business. And he didn’t have much fun, although that was a close one.

My colleague Peter Reilly, CPA, can add this to his list of successful defenses against the game-loss attack, Big Manager’s counter-gambit.

One of my analogies for audit representation is a game of Magic The Gathering, where each player builds their own deck from a universe of thousands of cards. I always want to have a stronger deck than my opponent and here is a new card for my hobby loss deck.