Horse and Cattle Operations - Guide to Avoid Hobby Losses IRS Section 183

Guide to Farm Hobby Losses With Cattle Operations and Horse Activities - IRC section 183:

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Introduction

The Market Segment Specialization Program (MSSP) Audit Techniques Guide (ATG) on IRC section 183 Farm Hobby Losses has been developed to provide guidance to Revenue Agents and Tax Auditors in pursuing the application of IRC section 183 with respect to horse activities and cattle operations.

Historically, IRC section 183 has been a difficult issue to pursue. The development of the issue is a fact-gathering initiative. The application of IRC section 183 is based upon the examiner's understanding of the taxpayer's industry as well as the taxpayer's mode of operation within that industry. IRC section 183 and the accompanying Treasury Regulations do not provide absolute definition, but serve to provide guidance in formulating the facts into a conclusion.

Hazards of litigation have also been a deterrent toward the pursuit of IRC section 183. As a result, examiners have been reluctant to allocate exam time. This ATG will help to further develop the weaker areas within these cases and reduce the hazards of litigation.

While IRC section 183 has been referred as the Hobby Loss section of the Internal Revenue Code, examiners should refrain from using such terminology. The actual language of the Code refers to "Activities Not Engaged in for Profit."

Some taxpayers resist this "hobby" terminology and the implications therein. For whatever reason taxpayers have engaged in these activities, albeit for the pleasure of a hobby or the tax benefits derived, these activities were not engaged in for the sake of deriving a profit.

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The examiner should use this guide during all phases of an examination where the provisions of IRC section 183 may be applicable. The purpose of the ATG is to:

• Provide background about the market segment.

• Identify frequent and/or unique issues.

• Provide examination techniques.

• Discuss use of applicable law and court cases.

This guide is not designed to be all-inclusive.

OBJECTIVES

The use of this audit techniques guide will enable the examiner to:

1. Identify and develop issues specific to the market segment.

2. Conduct an examination consistent with other market segment examinations throughout the Service.

Chapter 1

Market Segment Definition and Overview

PURPOSE

This chapter describes horse activities and cattle operations in an overview format. Special emphasis will focus on the application of IRC section 183 to each market segment. This provides the examiner with necessary background information to have a working knowledge of the market segment.

The following text provides the examiner with a brief overview of both cattle operations and horse activities.

DEFINITION

A brief description of the business types covered in this chapter will be discussed.

While any activity engaged by the taxpayer could potentially fall under the provisions of IRC section 183, the focus of this ATG is horse activities and cattle operations. Current trends indicate that these two activities, due to their nature, contain certain opportunities for taxpayer abuse. Examiners need to gain an understanding of these activities to make a determination whether the provisions of IRC section 183 will apply to their taxpayer.

BACKGROUND

The historical perspective of each market segment are reviewed.

Many of the taxpayers who potentially fall under the provisions of IRC section 183 with respect to horse and cattle activities have been involved in such

activities during their youth. These taxpayers have grown up on farms or had close relatives who operated farms. Other taxpayers had unfulfilled childhood aspirations to be involved with such activities, but circumstances prevented participation. As adults, these taxpayers have achieved the financial wherewithal which permits participation.

The taxpayers who have had prior experience in these activities find peace and solace in returning to this lifestyle. These taxpayers have affection for the horses as well as the cattle. The taxpayers find pleasure and satisfaction from watching their herds and baby animals grazing in the pastures. Examiners will frequently find retirement homes nestled on the land set aside for the activity.

Horse activities provide a competitive outlet for some taxpayers. For example, some taxpayers have been quoted as saying that cutting horse competitions provide stress relief from the chaos in the corporate world. Some taxpayers have found that agricultural status will reduce the property taxes on their land. Small numbers of cattle have been maintained on large parcels of land in order to qualify for this agricultural status. In such situations, the cattle activity was not engaged in for profit, but rather for the purpose of reducing property taxes. In other words, taxpayers have engaged in horse and cattle activities to reduce taxable income for Federal income tax purposes and to reduce property taxes. The property tax benefit is more attractive with land parcels that are larger than a few acres.

CURRENT STATUS

This section includes current information about horse activities and cattle operations. Discussion includes current trends, unique business practices, and forms of operation.

Horse Activities

Between the two activities of horses and cattle, horse activities more readily lend to the provisions of IRC section 183. Many publications have been written that direct taxpayers to use horse activities as a means to incur tax losses. These articles teach the taxpayer how to skirt the provisions of IRC section 183. Thus, the phrase "horse shelter" has evolved. If any taxpayers have followed this lead, then these taxpayers have entered the activity without a profit motivation; however, no taxpayer would ever confess this reason for entering an activity.

Horse activities encompass a broad span of activities for which a taxpayer may participate. A taxpayer can participate in one activity exclusively or in a combination of the activities. Some of the activities, when combined together, may or may not generate expenses that are ordinary and necessary. For example,

Showing Expense would not be an ordinary and necessary expense to Gross

Receipts derived from horse boarding. This concept will be discussed in further detail later in the text.

Horses are like athletes. They can be trained to perform events or to work certain jobs. Therefore, some horses will be frequently referred to as performance horses or working horses. Performance horses may be further distinguished by the event for which they have been specially trained. Such references would include, but are not limited to, roping, cutting, reining, and so forth.

At times, horses are referenced by the inherent qualities possessed by virtue of their bloodlines. Hence, a horse may be called "Halter bred" if his or her

bloodlines come from a lineage strong in Halter horses.

Halter horses are not considered Performance horses. Halter horses are defined by their muscular build. They are judged for their conformation to their breed characteristics and standards. Halter horses are not ridden in competition.

Instead, halter horses are shown with the exhibitor leading the horse from the ground.

Horses are further distinguished by breeds. For example, there are Appaloosas, Arabians, Palominos, Morgans, Saddlebreds, National Show Horses, Tennessee Walkers, Thoroughbreds, Quarter Horses, Warmbloods, Paints, Pintos, draft horses, Andalusians, Peruvian Paso, Miniatures, and ponies. (This is not an allinclusive list). Each breed is known for significant attributes which distinguishes that breed from other breeds; however, more than one breed may be used to perform certain events. For example, both Thoroughbreds and Quarter Horses may be used for racing. While Thoroughbreds are generally more proficient for racing by virtue of genetic breeding, Quarter Horses have also proven themselves to be successful on quarter-mile tracks.

Each horse breed has its own breed association. These associations govern the registrations of their horses, set forth rules and regulations governing

competitions, and oversee their Code of Ethics or Conduct. Any breeders who violate the guidelines may be suspended from the breed association for certain infractions.

Examiners should determine which breed association governs the taxpayer. The examiner can gain a wealth of information from these breed associations such as the number of horses registered by the taxpayer in a given year, any rules infractions or violations, or points earned in competitions. The examiner will most likely need to use a summons to gather information specific to a taxpayer.

However, general information regarding the breed and the breed association is provided for free. A telephone call from the examiner will be sufficient in order to receive such promotional materials. Many times this information is also published in the respective breed journals. The examiner may be able to gather breed association information from the Internet in districts where access is available. This information can be used to paint a picture of the taxpayer’s situation and help determine the applicability of IRC section 183.

Horse Training

Training Expense can be either an ordinary and necessary expense or a nondeductible, personal expense.

A horse must be trained to make it useful by people. The training process can be an ongoing process with varying stages, depending upon the use and intended purpose of the horse.

In theory, a horse should have a higher market value upon successful completion of its training; however, a weanling with highly desirable bloodlines and genetics may sell at a high market price without any training at all.

After horses have been broke to ride with a saddle, they may receive additional specialized training to learn performance events such as cutting or reining.

Depending upon the taxpayer's expertise and background, the taxpayer may choose to train his or her own horses. Most frequently, trainers are hired to train the horses for the taxpayer. This process is sometimes referred to as "putting time on the horse." Training is incurred in 30-day increments. Time spent on specialized training would be contingent upon the needs and learning capacity of the individual horse.

The cost for training includes the trainer's time, board, and care while the horse is at the trainer's facility.

Examiners should determine what local trainers generally charge in their respective districts. Examiners should consider profit motivation in situations whereby significant training fees are expended with little or no gross receipts derived from the activity. Examiners should determine why the horses are being trained. Are the horses being held primarily for resale? Are the horses to be used in competitions with prize money to be earned? Do the gross receipts derived, if any, justify the expenses incurred to train the horses?

When training fees exceed gross receipts or the reasonable expectation of gross receipts, the examiner needs to consider the profit motivation of the taxpayer.

Boarding

Boarding horses can be a source of revenue or a deductible expense under IRC section 162. In certain situations, boarding may be a personal, nondeductible expense.

Taxpayers can derive substantial income from boarding horses. Examiners need to determine standard boarding rates in their respective districts. Boarding fees are set according to services provided for the boarders. The most common boarding plans include full care, partial care, and self care. Examiners need to determine which type of plan that the taxpayer is utilizing.

Full care boarding generally provides that the stable performs all basic care of the horse. This care includes feeding twice daily, cleaning the stall, and turning the horse out for exercise. The stable also supplies the feed and hay for the horse.

Additional fees may be charged to the boarders for worming and farrier visits, if provided by the stable. Full care boarding is the most expensive of the three boarding plans.

Partial care boarding generally provides that the stable feeds the horse, but the owner is responsible for all other care needs such as cleaning the stalls. The examiner should review the boarding agreement to define the responsibilities of each party. Partial care boarding is less expensive than full care boarding.

Self-care boarding generally provides that the stable supplies a stall for the horse and the owner is responsible for all remaining care of the horse. The owner must feed the horse and clean the stall. The owner must also provide their own feed and hay. Since the stable only provides stalls and no other services, this is the least expensive method of boarding for the owner.

The examiner's understanding of the boarding arrangements will prove significant as the examiner determines the nature of the expense as well as the level of the taxpayer's participation.

Boarding horses can be an ordinary and necessary expense under the provisions of IRC section 162 depending upon the horse activity. However, boarding expenses can also be personal in nature. Boarding expenses can also be indicative of a passive activity. Examiners need to develop the facts of the situation to determine the proper tax treatment of these expenses.

Boarding expenditures can be incurred for a variety of situations. Examiners should be alert for situations where the taxpayer boards the horse and acts as an absentee owner. The examiner needs to consider the taxpayer’s business intentions for owning the horse.

Horse Competitions

Horse competitions can be an important part of raising horses. These

competitions provide a tool for measuring the performance ability of each horse.

A horse that has earned many points is more marketable than a horse that has

earned fewer points or none at all.

Horse competitions can provide revenue for the owner; however, not everyone

can be the winner. Show prizes won may not cover the costs incurred to win the

prizes. Entry fees will vary depending upon the show and the status of the show.

In addition to entry fees, stalls may be rented depending upon the length of the

show. Desirable stall locations frequently command a higher stall rent. In other

words, stalls located with easiest access to the show arena may rent for a higher

fee.

Horse competitions can be useful for proving the merits of a horse; however,

examiners should be alert for hobby potential. When a taxpayer consistently

incurs significant show-related expenditures in conjunction with the showing

activity, and the showing activity does not generate significant prize earnings or

sale of horses, the examiner should consider the profit motivation of that taxpayer.

Since some competitions award trophies and rosettes instead of cash prizes or

points, examiners should determine specifically what the taxpayer is gaining from

the showing activity.

Examiners should determine the specific classes in which the taxpayer

participates. Examiners should also gain an understanding of the rules governing

these classes because some classes evaluate the horse while other classes evaluate

the rider. In the instances where the taxpayer has a significant amount of show

fees deducted on the tax return, the examiner would find it worthwhile to

determine the composition of these show fees. If the taxpayer participates in a

significant number of classes whereby the taxpayer (rider) is evaluated instead of

the horse, the examiner should consider the taxpayer's motivation for such

participation. Regardless of class participation, significant show fees in relation

to minimal show prizes could be indicative of a hobby motivation.

Other Expenses

Horse activities have other expenditures in relation to the activity. The examiner

needs to evaluate each expenditure as it pertains to the taxpayer’s situation and

determine the deductibility under IRC section 162. After evaluating the whole set

of facts and circumstances, the examiner needs to determine if the taxpayer is

engaged in the activity with the intention of deriving an overall profit from the

activity under the provisions of IRC section 183. The following expenditures are

discussed to develop an understanding of the expenditure and how it applies to the

individual taxpayer.

Any of the following expenses can be ordinary and necessary under IRC section

162 in the instances where the taxpayer has engaged in the activity for profit.

However, if the examiner deems the activity not to be engaged in for profit, then

the expense would be limited in accordance with IRC section 183. The

limitations will be discussed in detail later in the text.

FEED EXPENSE is a common, self-explanatory expenditure. In the instances

where the taxpayer has always boarded his or her horses, the tax return may not

reflect any feed expense. The boarding expense would include the cost of feed

for the horses in board. Examiners should be alert for feed expenditures for animals that are not integral to the operations of the activity. For example,

expenses for the family’s toy poodle may be contained and deducted within the

feed expense. (Such personal expenses may be scattered throughout the other

expenses as well).

INSURANCE EXPENSE can be an ordinary and necessary expense for the

activity. The examiner should review the policies to determine the type of

coverage and the asset protected by the coverage. The examiner should be alert

for personal, nondeductible items. Horse insurance companies provide a variety

of coverage, such theft, mortality, medical, liability, and loss of use, to name a

few. Loss of use coverage is commonly obtained for horses that are utilized for

specific purposes or “use”. If the horse becomes unusable for that specific use

because of injury, then the owner is compensated for the loss of use of that horse.

Insurance expense can be an indication that the taxpayer is trying to protect his

investment. The examiner should weigh all facts and circumstances. The

examiner should not conclude that an activity is engaged in for profit based solely

upon the presence of insurance coverage.

Horse insurance companies state that policies are purchased by a variety of horse

owners for a variety of reasons. Backyard ponies may be insured for a minimal

amount if the owner does not have the financial wherewithal to readily replace the

animal. Other wealthy horse owners may weigh the risk of loss against the need

for insurance coverage. The owners may decide to forego coverage and elect to

buy another horse should actual loss occur. For these owners, the replacement

cost is insignificant. Nonetheless, the examiner should decide if the absence of

insurance shows a lack of business prudence.

MARE CARE EXPENSE is generally incurred during the gestation cycle of the

mare’s pregnancy. The expense can include breeding the mare and providing

postpartum foal care as well. The mare will often be sent to a special mare care

facility, breeding facility, or mare motel. The examiner should consider the

taxpayer’s level of participation with respect to the activity in the instances of this

expense coupled with other expenditures indicative of passive participation (such

as boarding).

BREEDING FEES EXPENSE includes stud fees and any related veterinary

costs. Booking fees would be paid to ensure a reservation for the mare to breed

with the stud. Many stud owners limit the number of mares during the breeding

season. The show record and progeny record of the mare may also be a criterion

because the stud owners want their studs bred to top quality mares. These owners

believe that quality offspring result from quality pairings. They do not want

substandard-quality offspring produced with their stud’s name in the pedigree.

Not all stud owners hold to these criteria for varying reasons. For example,

owners of unproven studs or studs with limited showings might not be particular

about the mare’s record. (An unproven stud is generally young and does not have

offspring produced to date to measure his abilities).

Horses may be bred using artificial insemination or naturally (live cover). The

method of live cover can subject either horse (mare or stud) to injuries related to

the process, such as biting or kicking. Owners may not wish to subject valuable

horses to such potential injuries and elect to use artificial insemination. In

general, artificial insemination is the more expensive method. The taxpayer’s

choice of method is a matter of preference and not an indication of profit motive.

PRACTICE CATTLE EXPENSE pertains to cattle used as a practice aid for

cutting horses. Practice cattle need to be exchanged periodically so that the

cutting horses are using “fresh” cattle. Practice cattle can be rented at cutting

horse competitions. In such instances, practice cattle would be an expense to the

taxpayer. Sometimes, the taxpayer may wish to maintain his or her own practice

cattle at his or her horse facility. In such instances, the taxpayer will purchase

cattle and use them for a period of time. After the cattle are no longer “fresh”, he

or she will sell them at a sale barn and purchase new cattle.

The examiner should determine the exact nature of the practice cattle. The

taxpayer may fail to report the income derived from the sale of practice cattle

maintained on his or her cutting horse facility.

Cattle Operations

There are several methods for operating cattle activities. While these methods

have similarities, there are also differences.

Cattle operations have developed the use of various data to monitor productivity

of the cattle and the profitability of the cattle operation. As a result, many terms

and definitions have evolved. The glossary at the end of this guide explains some

of these terms. The examiner may also contact the local County Agricultural

Extension Agent for additional information.

The biggest distinguishing factor among cattle operations lies within the

registration of the herd. A taxpayer may choose to register his or her herd with a

recognized breed association. This choice mandates that the taxpayer adheres to

policies set forth by the governing breed association. These policies are designed

to preserve the purity and integrity of the breed. The breed association also

requires that records be maintained to track the productivity of every registered

animal.

Taxpayers may choose not to raise registered purebred cattle. Depending upon

regional phraseology, an unregistered herd may be referred to as a

COMMERCIAL HERD. While such a choice relieves the taxpayer from the government of a breed association, the taxpayer still needs to maintain a

recordkeeping system that tracks the efficiency of the cattle operation.

Types of Cattle Operations

Cattle operations can be further defined by the end product. Cattle operations

may produce one or a combination of products for sale.

COW-CALF OPERATIONS are comprised of a herd of cows that produce an

annual calf crop. These calves are sold after they are weaned from their mothers.

The taxpayer has several options for marketing these calves.

Calves may be sold as FEEDER CALVES. The buyers may be feedlots, who

buy weaned calves and feed these calves until slaughter weight. The taxpayer

may raise the feeder calves and sell them to a packer when slaughter weight has

been achieved.

Calves may be sold as BREEDING STOCK, registered or commercial, to other

breeders. The taxpayer may retain some of his or her heifer calves for

REPLACEMENT HEIFERS in his or her own breeding program. Any calves

sold for breeding stock may be heifers, bulls, or both.

Live calves are not the only products from cow-calf operations. Modern medical

technology has enabled cattlemen to sell semen from prized bulls. EMBRYOS

from prized genetics may also be sold. SEMEN SALES require that the taxpayer

issue breeding certificates. The examiner could verify income from semen sales

through these breeding certificates.

The taxpayer will have incidental income from the sale of CULL CATTLE at the

local sale barn. Culls may be sold singly or in small group. The examiner should

be alert for cull sales because these smaller sales are frequently overlooked in

calculating income from the activity. Checks received from the sale barn may be

cashed and not deposited into the bank account.

The examiner needs to establish the taxpayer’s method of operation with respect

to the cattle activity, or the horse activity, during the Initial Interview.

Books and Records

Horse activities and cattle operations have unique recordkeeping systems.

Completeness of these books and records should be considered while the

examiner develops Factor One, Manner in Which the Taxpayer Carries on the

Activity.

Books and Records for Horse Activities

Recordkeeping for horses should be complete and useful so the taxpayer can

make informed business decisions about the activity. Horse records are similar to

cattle operations except horsemen do not concern themselves with any weightrelated

data. Horsemen should focus on the production and performance of each

horse and any resulting offspring of each horse. Superior production and

performance will impact the profitability of the activity.

Complete and accurate contemporaneous field records will ensure accurate

pedigrees for the certificates of registrations. This is a requirement for

compliance with any governing breed association.

The examiner should be aware that many breed associations offer online Internet

access to members that enable access to show winnings, pedigrees, and other data

maintained by the association. The examiner should discern whether the taxpayer

maintains any separate records or if the taxpayer relies upon association records.

Books and Records for Beef Cattle Operations

The examiner should be alert that some taxpayers may not maintain the

contemporaneous records necessary to satisfy the requirements of the breed

association. Some of the data may be “plugged.” Contemporaneous records

would include some type of field book that is carried out to the pasture. The data

would be transferred from the field book to a permanent record.

Contemporaneous records lend to the reliability of the herd’s production records.

Unreliable records will not assist the taxpayer in making informed business

decisions about the cattle operation. The examiner should review the

recordkeeping process and make comments regarding completeness. The

taxpayer’s use of incomplete records could indicate a lack of profit motive.

The taxpayer may choose not to register his or her herd with a recognized breed

association. While recordkeeping burden has been reduced, the taxpayer should

still maintain meaningful production records in order to track production and

control profitability through informed business decisions.

Meaningful production records will work much like a cost accounting system.

Each cow, bull, and steer is a unit of production. The bulls and cows will produce

calves. The steers will produce beef carcasses. The efficiency of each producer

should be monitored.

Example 1

A cow-calf operation would monitor birth date (calving date), sex of the

offspring, birth weights, weaning weights, and yearling weights for each calf

produced. The production records may also show data regarding the cow’s milk

production for the calf.

Example 2

A feeder steer operation would monitor type of feed, percentage of feed

ingredients, beginning weight, daily rate of gain (weight), weight per day of age,

slaughter weight, and USDA yield grade of carcass.

Factor One addresses the manner in which the taxpayer carries on the activity.

While the completeness of the taxpayer’s records may indicate a profit motive,

the examiner must evaluate the taxpayer’s operation from the perspective of all

nine relevant factors.

FUTURE OUTLOOK

Several publications have promoted the use of horse activities as a means to lower

taxable income. Thus, the term “horse shelter” has been coined. These

publications have skirted the provisions of IRC section 183. Cattle operations

have also enabled taxpayers to lower their taxable income. These “shelters” have

been attractive because the Internal Revenue Service has not aggressively pursued

this issue in times past for various reasons. United States Tax Court cases have

ruled both ways and encouraged the taxpayer’s engagement of such activities.

In general, taxpayers in higher income tax brackets will benefit from the

engagement of these activities. Improved case development will further the

Government’s success in litigating this issue and reduce the taxpayer’s abuse of

this Internal Revenue Code section.

RESOURCES

There are additional IRS resources available to the examiner. Resources include:

• Technical Advisors

• Project Coordinator

• District Market Segment Specialization Program Coordinator

• General Livestock Audit Technique Guide

• Farmer’s Tax Guide, IRS Publication

Chapter 2

Issues

PURPOSE

This chapter discusses specific issues applicable to horse activities and cattle

operations. These issues are limited to those which are frequent or unique to the

horse and cattle market segments.

Frequent issues occur regularly in the market segment. For example, showing

horses and cattle, without regard for costs versus benefit, is encountered

frequently.

Unique issues are found only within the market segment. For example, the

history of losses issue is unique to the IRC section 183 cases.

ISSUES

Issues specific to each market segment will be discussed. This discussion will

include the following points:

• Overview of the issue

• Automatic adjustments apparent on the face of the return (for example,

depreciation methods used for breeding stock and farm equipment)

• Frequency

• Discussion of each of the nine relevant factors.

PRE-EXAMINATION ANALYSIS

The examiner needs to develop the ability to inspect a tax return and determine

the potential for that taxpayer's activity to fall under the provisions of IRC section

REVIEW OF TAX RETURN

Examiners need to consider a number of aspects about the tax return. Inspection

of the tax return needs to include certain relevant factors as contained in the

Treasury Regulations for IRC section 183. The nine relevant factors of Treasury

Regulation section 1.183-2(b) are discussed later in the text.

Observe whether the activity has any gross income. In many instances, there will

be little or no gross income. Consider the source of the income. This information

may be contained on a separate statement within the tax return. The source may

not be directly related to the activity as specified on the Schedule. In order to

legitimize the activity as a business, or make it appear as an activity engaged in

for profit, a taxpayer may place income from wholly unrelated sources to offset

the large expenses for the activity.

A separate statement may indicate “Show Prizes” as an income source. Another

separate statement may explain “Other Expenses” to include a significant amount

of show expenses that far exceed the income derived from “Show Prizes.” This

should alert the examiner to a strong indication that a hobby may be present.

Consider why the taxpayer’s costs (show expenses) of the activity have exceeded

the benefits (prizes or sales).

The examiner will need to secure the original returns for each year that the

taxpayer has conducted the activity in the event that District Counsel litigates the

case in United States Tax Court.

REPORTING ON SCHEDULE C OR SCHEDULE F

Taxpayers have been reporting cattle operations and horse activities on Schedules

F as well as Schedules C. The taxpayer's choice to utilize Schedule C or Schedule

F is not a determinative consideration in the application of IRC section 183.

Taxpayers have their own justification for using either Schedule C or F. The use

of either Schedule is acceptable and has no bearing in proving whether an activity

is engaged in for profit. Classifiers and examiners should be alert that the use of

Schedule C could potentially disguise the nature of a farming activity that would

be subject to the provisions of IRC section 183.

HISTORY OF LOSSES

The examiner needs to obtain information regarding the taxpayer's history of the

activity under consideration. During the pre-examination analysis, the examiner

could gain such information from a MACS 3-year printout or from Information

Data Retrieval System (IDRS). The examiner should defer to whichever method

is most readily available and recommended in the examiner's district.

The examiner needs to review the history and determine if the activity is

generating any profits in any years at all. If the taxpayer has received any profits

on an occasional basis, the examiner should determine if the overall history of

losses exceeds the occasional profits.

IRC section 183(d) addresses the presumption that if an activity’s gross income

exceeds attributable deductions for 3 or more of the taxable years in a period of 5

consecutive taxable years, then the activity is presumed to be engaged in for

profit, regardless of whether the activity is engaged in for profit. For the purpose

of this text, cattle operations fall under this presumption. Activities that pertain to

the breeding, training, or showing of horses should observe a profit in 2 or more

of the taxable years in a period of 7 consecutive taxable years.

Aside from the presumption stated in IRC section 183(d), Treasury Regulation

section 1.183-2(b)(6) addresses the taxpayer’s history of losses with respect to the

activity and provides further clarification. Unforeseen or fortuitous circumstances

can impact profitability and should be considered.

Treasury Regulation section 1.183-2(b)(7) addresses the occasional profits, if any,

that are derived from the activity. The examiner should consider whether there is

any reasonable certainty that profits could occur again or if these occasional

profits are not likely to be repeated. Insignificant, occasional profits are not

indicative of an activity engaged in for profit. However, occasional substantial

profit may be indicative of an activity engaged in for profit. The examiner should

bear in mind that no one factor is determinative.

In general, a taxpayer that has the potential for falling under the provisions of IRC

section 183 will be incurring losses that tend not to diminish with each subsequent

year. While depreciation expense may cause losses in the beginning years of the

activity's operation, eventually such losses should start to level out as the annual

depreciation expense begins to decrease. In other words, the activity's losses will

continue to remain the same even though annual depreciation should start to

decrease.

The examiner may utilize master file data in order to ascertain a loss history

during the pre-examination analysis. Copies of prior year's returns will need to be

secured for the case file. Such copies can be obtained from the taxpayer or the

taxpayer's representative. Original tax returns may become necessary should a

case go forward to the United States Tax Court. At that point, the examiner

should defer to Counsel.

LARGE, UNUSUAL, OR QUESTIONABLE ITEMS

Like any other examination, the examiner should consider any large, unusual, or

questionable (LUQ) items contained on the Schedule which the activity is

reported. In addition to the presence of any LUQ items, the examiner should

consider the relationship of certain LUQ items to other items on the Schedule. In

the situations where the provisions of IRC section 183 may be applicable, the

relationship of any LUQ expense item should be compared to the gross receipts

derived from the activity.

For example, minimal gross receipts derived from showing in relation to a

significant amount of show-related expenses could be indicative of an activity not

engaged in for profit.

GROSS RECEIPTS

Examiners should be alert to the nature of the gross receipts that have been

reported on the Schedule. Determine that the income source truly relates to the

activity contained on the Schedule. Examiners should also determine that the

income source truly exists as some taxpayers have manufactured income in order

to make it appear as though the activity earned some income.

Manufactured income raises a potential fraud issue. Examiners should follow

local procedures in such instances.

Examiners should also be alert to situations where the reported gross receipts

pertain to a bona fide business-type activity, but certain expenses have been

deducted which are personal in nature or otherwise nondeductible under IRC

section 162. For example, the taxpayer receives gross income from boarding

horses for other individuals. The gross receipts are reported correctly on

Schedule C or Schedule F. The taxpayer has deducted expenses for show entry

fees, transportation to shows, grooming and daycare expenses at the show. These

expenses do not pertain to the boarding activity from which the taxpayer derives

gross income. During the Initial Interview, the examiner learns that the showrelated

expenses pertain to the taxpayer's personal horses. The show-related

expenses are nondeductible under IRC section 162.

The previous example demonstrates how nondeductible expenses can be present

among other deductible expenses. While the example does not specifically

address the provisions of IRC section 183, the example does lead the examiner to

a clue or indication that circumstances do exist that could possibly fall under the

provisions of IRC section 183. The examiner needs to follow up and pursue the

IRC section 183 potential in greater depth. Personal expenses can be indicative of

an activity not engaged in for profit.

OTHER SUBSTANTIAL INCOME SOURCES

Current examination results indicate trends that taxpayers who have the greatest

potential for falling under the provisions of IRC section 183 have other substantial

income sources outside of the activity in question.

Taxpayers with other substantial income sources generally have the wherewithal

to sustain significant financial losses from horse activities or cattle operations.

The examiner needs to determine if the taxpayer is sustaining financial losses

from the activity in order to offset the other substantial income sources.

The examiner should prepare a spreadsheet that details the tax savings benefit

from the operation of the activity. An example of such a spreadsheet is contained

in the Appendix of this guide.

Tax Court litigation regarding IRC section 183 has addressed the aspect that

certain taxpayers have proven themselves to be capable of financial success in

other ventures, but manage to sustain a history of significant financial losses with

respect to the activity in question. The tax savings benefit analysis illustrates

motivation for the taxpayer to continue an otherwise unprofitable activity.

Factor 1: The Manner in Which the Taxpayer Carries on the Activity

Factor 1 addresses the manner in which the taxpayer carries on the activity. The

examiner will document facts and information regarding the taxpayer’s activity as

derived from the Initial Interview, as well as from the course of the examination

process.

Books and Records Used in the Activity

The examiner needs to inquire about the books and records maintained for the

activity during the Initial Interview. The examiner should document in the

workpapers regarding the sophistication of the taxpayer’s books and records.

Determine if the taxpayer maintains separate checking accounts for the activity

from the taxpayer’s personal living expenses.

Depending upon the volume, the examiner should obtain photocopies of the

taxpayer’s entire set of books and records. If photocopying the entire set of books

and records proves to be cost prohibitive, the examiner should only photocopy

samples representative of the overall books and records.

Registered breed associations for both cattle and horses offer computer software

programs which monitor pedigrees, breeding information, chores, and so forth. In

order to register animals with these breed associations, accurate breeding

information is mandatory. Cattle breed associations are currently tracking various

production data about the registered animals such as birth weights and weaning

weights. The examiner needs to determine what type of contemporaneous

recordkeeping system the taxpayer uses to record this data. The information

provided to the breed association is only as reliable as the contemporaneous field

records maintained by the taxpayer. These records must be timely.

The presence of sophisticated books and records does not automatically equate to

profit motive. The taxpayer must be relying upon these records in order to

operate the activity and make decisions or changes. The examiner needs to

document how these records are utilized by the taxpayer. It is not sufficient for

the taxpayer to maintain production data, if only for the purpose of satisfying the

breed association. The taxpayer should be using the production data in order to

determine which animals to keep and breed or which animals to sell. In other

words, the taxpayer should not plug production figures in order to satisfy the

breed association. This data should be used as a management tool in the daily

operation of the activity.

Business Plan

The taxpayer should have a formal written plan. This plan should demonstrate the

taxpayer’s financial and economic forecast for the activity. The plan should not

be a “fantasy Schedule F or C.” In other words, some taxpayers may wish to

submit a business plan that is nothing more than a Schedule F or C, which

unrealistically overstates the gross receipts and unrealistically understates the

expenses for the activity. This is not an acceptable business plan.

As previously stated in the text, the examiner should not request the business plan

in the first Information Document Request (IDR). Otherwise, the examiner will

possibly receive a “canned” document. The examiner should inquire as to the

business plan during the Initial Interview and follow-up with a subsequent IDR.

A business plan should show a short range and long range forecast for the

activity. The forecast should allow for changes due to potential unforeseen and

fortuitous circumstances.

The plan should be realistic. The examiner should perform quantitative analyses

in order to determine the reasonableness of the projected gross receipts and

various expense items. The examiner may consult with IRS economists in order

to review the business plan. The examiner may also consult with local

Agricultural Cooperative Extension Agents in order to obtain quantitative

formulas to scrutinize the figures projected on the business plan.

For example, the examiner can calculate, with reasonable certainty, the amount of

feed required to maintain a certain number of cattle in a particular geographical

region. The examiner can start with the taxpayer’s projected number of cows

required to generate a specific size calf crop. Multiply the number of requisite

cows by the amount (in pounds) of feed and hay required to maintain the cows

annually. Multiply the pounds of feed by the price per pound for feed.

The examiner can also determine whether the taxpayer’s activity would have been

profitable if he or she achieved his business plan. For example, a taxpayer has a

business plan that includes the goal of maintaining 100 head of cattle in his or her

herd. Even if the herd size is increased to 100 head, he or she still could not

realize a net profit because he or she could not overcome current operating

expenses. Furthermore, the taxpayer does not have sufficient acreage to support

100 of cattle. As such, his or her business plan is not realistic and not likely to

generate a net profit.

Methods of Operation

The examiner needs to document the taxpayer’s method of operation. As

previously mentioned in the text, taxpayers will not operate within the same

activity in exactly the same way. The examiner should document the daily

operation as well as the history of the activity’s operation in the workpapers.

Denote changes in the method of operation over the years and indicate why these

changes were initiated. Most of this information will be gathered during the

Initial Interview.

Efficiency of Operation

The examiner needs to document the efficiency of the taxpayer’s operation.

Denote the taxpayer’s use of any experts or specialists. Indicate if any changes

were initiated and why. Obtain names, position titles, and addresses. Most of this

information will be gathered during the Initial Interview.

The examiner will denote whether the taxpayer is making changes to the

operation that will result in improved operational efficiency. For example,

indicate whether production records are used to select animals for removal from

the activity. Ask the taxpayer what criteria are used for selecting animals to be

used for the activity’s program regardless of the activity. Appendix D includes

such sample questions.

Issue Identification

The examiner needs to review the actual copy of any advertising in instances

where the taxpayer has deducted such expenditures. Many taxpayers will buy

advertising space for “vanity” ads. These spaces are frequently purchased to

place photographs of their children and the children’s horses. The ads wish the

children “Best of luck” prior to upcoming show competitions. The examiner

should use professional judgment to determine whether the advertisements truly

represent promotion of the taxpayer’s horse activity.

The examiner needs to be alert for the children’s horse activities being deducted

on the parents’ tax return. The examiner needs to review show reports and

determine who actually competes in the horse shows. The parents may contend

that the children are promoting the horses for the activity through the show

competitions. The examiner needs to consider the substance of the facts. A

determination should be made whether the show related expenses are truly

recouped through the subsequent sale of any horses. In many instances, great

sums of money are expended for show fees, shavings, stall rents, schooling,

training, braiding manes and tails, show transportation, travel, and so forth. If and

when any horses are sold, the sales price does not justify the means.

Depreciation and Inventory can be viable issues for the examiner to consider as an

aside from IRC section 183. The examiner should develop a clear understanding

of the taxpayer’s activity and verify that the proper tax treatment is used for the

horse activity. Horses that are used for breeding purposes are considered

depreciable assets. Horses that are held primarily for resale are not depreciable

assets.

Example 1

A taxpayer has deducted depreciation expense for show horses because those

horses are being “used up” during use in show competitions. However, the

taxpayer has also contended that these same show horses are being held for

resale. The examiner should consider substance over form and determine

whether the horses are being held as inventory for resale or if the horses are

depreciable assets.

Examination adjustments for the aforementioned example could impact

depreciation expense or the reportable gain on the sale of any horses. This issue

can become complex. The examiner should review IRC section 167 for a

discussion of depreciation. Most taxpayers who potentially fall under the

provisions of IRC section 183 will likely fall outside of the criteria of IRC section

263A due to the amount of the taxpayer’s assets.

Summary of Factor 1

The examiner must document the manner in which the taxpayer carries on the

activity. Most of this information will be gathered during the Initial Interview and

the tour of the operation. It is important for the examiner to document a clear

understanding of the activity. Assumptions should not be made that each cattle

operation or horse activity operates the same as another similar activity.

Factor 2: The Expertise of the Taxpayer or His or Her Advisors

Factor 2 addresses the expertise of the taxpayer or his or her advisors. The

examiner should document the extent to which the taxpayer has relied upon his or

her advisors. The examiner should also document the instances where the

taxpayer received advice from his or her advisors, but failed to heed this advice.

Decisions and Changes to Operation

The Initial Interview should include questions regarding the taxpayer’s expertise,

the use of any experts, and any changes or decisions regarding the operation of

the activity.

The examiner should establish and document the taxpayer’s background in the

activity and determine how long the taxpayer has been engaged in the activity.

Many times the taxpayer was involved in the activity in some capacity during

youth and later became involved again as an adult. These adults have re-entered

the activity after they have obtained the financial wherewithal to commence the

activity. The examiner should establish a history of the taxpayer’s growth of

knowledge within the activity and how this knowledge was obtained.

The examiner should establish if the taxpayer has used any advisors or experts in

the operation of the activity. Obtain names, position titles, and addresses of these

advisors. Document how the advisors were chosen by the taxpayers. Establish

the credentials of the advisors. Document if a personal relationship exists

between the taxpayer and his advisors.

The examiner needs to document specific instances where the taxpayer was

provided advice that was implemented in the activity. Describe how this

information affected the operation and any resulting changes. Document whether

the advised changes were successful or unsuccessful.

The examiner also needs to document specific instances whereby the taxpayer

was advised by his or her experts to make changes and the taxpayer ignored the

advice. The examiner should document why the taxpayer chose to ignore this

advice. Many taxpayers will provide names of advisors in an effort to

demonstrate profit motivation. However, if the taxpayer chooses not to

implement the suggested changes and cannot provide just cause for doing so, then

the taxpayer’s use of advisors is questionable.

Example 2

A taxpayer was advised by his ranch manager to eradicate mesquite brush from a

portion of the land. The additional ground would be available for cattle grazing

and would allow the taxpayer to increase the size of the herd. A larger herd would

result in a larger calf crop and increased potential for additional cattle sales. The

taxpayer had the financial wherewithal to eradicate the mesquite brush and the

taxpayer’s ranch manager was credible. Nonetheless, the taxpayer elected not to

follow the advice of the advisor and did not provide any business explanation for

his decision. Since the taxpayer also hunted on his ranch, he feared that the

eradication would impact the wildlife. In this example, the taxpayer lost

credibility with respect to this relevant factor.

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Summary of Factor 2

The examiner should document the expertise and knowledge of the taxpayer

regarding the activity. The examiner should also document any advisors or

experts that the taxpayer has used. Documentation should be prepared which

shows specific instances where the taxpayer has followed the advice of the

advisor. Documentation should also show how the advice affected the operation

of the activity. The examiner should especially note instances when the taxpayer

has ignored the recommendations of the advisor and why that decision was made.

Factor 3: The Time and Effort Expended by the Taxpayer in Carrying

on the Activity

This factor addresses how much time and effort is expended by the taxpayer in

carrying on the activity. In addition to the taxpayer’s time, the examiner needs to

consider the amount of time expended by any other individuals involved in the

activity. The development of this factor may lead to the development of an

alternative position under the provisions of IRC section 469 for Passive Activities.

Time and Effort Expended

The examiner needs to establish precisely how much time the taxpayer devotes to

this activity as well as all other activities. The amount of time devoted to the

activity may be an indicator of profit motive.

If the taxpayer devotes a limited amount of time to the activity, then the taxpayer

may be lacking a profit motive. However, if the taxpayer employs competent and

qualified individuals to operate the activity, then the taxpayer’s time and effort

will be reduced.

Time and effort expended reading magazines, journals, and other periodicals is

consistent with engaging in a hobby.

Passive Activity Treatment as an Alternative Position

After the examiner determines the amount of time that the taxpayer devotes to the

activity, then the examiner should consider the possibility that the provisions

under IRC section 469 for Passive Activity may apply to the taxpayer.

If the examiner determines that IRC section 469 may be applicable, then the

examiner could use IRC section 469 as an alternative position to IRC section 183.

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Issue Identification

The examiner should prepare an analysis that shows how much time is devoted to

the activity as well as a breakdown of how that time is spent. For example, the

examiner should designate how much is spent attending seminars, reading

magazines and journals, or how much time is spent performing repairs and

maintenance and so forth.

With respect to an activity that involves show competitions, the “downtime”

between the taxpayer’s classes in the competition is not counted toward the time

calculation. In other words, the time spent waiting between classes or events is

not counted.

The examiner should note specifically the amount of time that the taxpayer

devotes to other activities.

Summary of Factor 3

The examiner should consider the amount of time that the taxpayer devotes to the

activity. The time analysis should precisely detail how much time the taxpayer

devotes to each task related to the activity. The examiner should consider

whether IRC 469 Passive Activity provisions might be applicable. IRC 469 could

provide an alternative position for IRC section 183.

Factor 4: The Expectations That the Assets Used in the Activity May

Appreciate in Value

Factor 4 has been the most difficult of the nine relevant factors for examiners to

correctly develop. The taxpayer has generally been successful with respect to this

factor because of the potential for land appreciation. However, proper

development of this factor can overcome the potential for land appreciation.

Single Versus Separate Activities

Factor 4 hinges on whether the operation of the taxpayer’s activity and the

holding of the land are considered to be a separate or single activity.

According to the Treasury Regulations, Factor 4 states that the term “profit” also

includes the appreciation of assets, such as land, used in the activity. An overall

profit may occur, in spite of losses from current operations, if the appreciation of

the assets is realized.

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The examiner needs to prepare an analysis that shows the history of the activity.

Beginning with gross receipts, the examiner needs to separate current operating

expenses from the costs of carrying the assets. These carrying costs would

include depreciation and related interest expense.

The examiner needs to determine if gross receipts exceed current operating

expenses with a resulting net profit. For the purpose of this calculation,

depreciation expense and related interest expense should be excluded.

As previously mentioned, taxpayers can frequently show potential appreciation of

asset value, usually with respect to the land. However, the appreciation of the

assets may only be used as a consideration for overall profitably if the operation

of the activity and the holding of the assets are considered to be a single activity.

If the operation of the activity and the holding of the assets are considered to be

separate activities, then the appreciation of the assets will not be considered for

overall profit. In other words, if the operation of the activity and the holding of

the assets are considered to be separate activities, the history of operational losses

cannot be offset by the potential gain from assets’ appreciation.

In order to show that the operation of the activity and the holding of the assets

should be treated as separate activities, the examiner needs to refer to the previous

analysis. If gross receipts do not exceed current operating expenses, then the

operation of the activity and the holding of the assets will be considered as two

separate activities. As two separate activities, the history of losses cannot be

offset by the appreciation of the assets.

Taxpayer’s Intent for Land

Factor 4 relies upon future gain potential to offset current losses. The examiner

should inquire during the Initial Interview if the taxpayer intends to retire on the

site. Frequently taxpayers have purchased these properties for the purpose of

future retirement. If the taxpayer intends to retire on the property, then no future

gain will be realized.

Tax Court cases have gone both ways with respect to taxpayers who have

expressed retirement purposes as an intention for land acquisition. Nonetheless,

the examiner should document such intentions, if known. Since no one factor is

determinative by itself, the examiner should address the taxpayer’s intention for

holding the land.

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Computation

First, the examiner needs to begin with gross receipts for each year that the

activity has been in operation. Current operating expenses will be deducted from

gross receipts in order to determine if there is a current profit or loss from the

operation of the activity. Current operating expenses should not include

depreciation expense, related interest expense, or real estate taxes for the purpose

of this calculation. These expenses would be incurred regardless of the activity.

Issue Identification

The examiner should consider the potential for appreciation of the activity assets,

especially the land. This information can be gathered from comparables.

Comparables would show land values for properties similar to the taxpayer’s

parcel. Comparables can be obtained from area realtors. Comparables are

extremely important in determining land valuation.

The potential for asset appreciation should be documented on a separate

workpaper in the examiner’s case file.

Summary of Factor 4

The examiner needs to determine if a potential for asset appreciation exists. The

examiner can use comparables for this determination. The examiner also needs to

determine whether the operation of the activity and the holding of the land are

considered a single activity or separate activities.

In the instances of single activities, the history of losses from current operations

will be offset by the future potential gain. In the instances of separate activities,

the taxpayer cannot offset current operating losses by future potential gains. A

determination of separate activities will result in the taxpayer not meeting Factor

Factor 5: The Success of the Taxpayer in Carrying on Other Similar or

Dissimilar Activities

The examiner needs to document the taxpayer’s financial success in other

activities. This information will be gathered from prior year tax returns as well as

the years under examination.

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Success in Other Activities

The examiner will prepare a worksheet that details the history of other activities.

This detail should show the profits and losses derived from the activities.

In general, many taxpayers have achieved financial success in other business

endeavors and yet failed in the operation of the activity in question.

The examiner should focus on activities in addition to the taxpayer’s primary

source of income. For example, if the taxpayer is a medical doctor, the examiner

should not focus on his or her success with his or her medical practice. The

examiner should focus on success or failure of other unrelated ventures that were

conducted in addition to the medical practice, such as the operation of a restaurant

or a kennel.

In addition to the aforementioned worksheet, the examiner needs to document any

specific instances where the taxpayer has abandoned certain activities when those

activities have proven to be unsuccessful.

Summary of Factor 5

The examiner needs to document the financial successes that the taxpayer has had

with other activities. A statement should also address specific instances where the

taxpayer has abandoned any activities.

Factor 6: The Taxpayer’s History of Income or Losses With Respect to

the Activity

The examiner needs to document the history of income or losses generated by the

activity. This documentation should be prepared on a detailed worksheet with

any narrative as necessary.

While this factor may present the taxpayer in a negative light, examiners should

not use this relevant factor by itself in reaching a conclusion regarding the profit

motive of the activity.

History of Losses

Some of the nine relevant factors will overlap through the course of the

examination process. Information developed for one factor may be used in the

development of other factors.

Factor 6 is one of the most important factors of the nine. This factor supports the

framework of this Code section.

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The examiner needs to prepare a worksheet that shows a history of the activity’s

profits and losses. The examiner will need to gather prior year tax information

using Integrated Data Retrieval System (IDRS). The examiner should order the

original returns for any prior years that are no longer “online.” These returns

would be ordered for review purposes using local procedures.

The examiner can copy the original returns and place them in the administrative

file.

The original returns must be secured in the instances where District Counsel

proceeds with litigation in United States Tax Court.

Depreciation

The examiner should prepare the worksheet with a separate column that shows the

amount of depreciation that was deducted in each tax period. This separation is

required for use in the development of other relevant factors.

If the taxpayer has deducted other land carrying costs, such as real estate taxes or

related interest expense, then these expenses should be shown in a separate

column. Such real estate taxes and mortgage interest would be deductible on

Schedule A subject to AGI phase-out limitations.

Summary of Factor 6

IRC section 183 focuses on the lack of profit potential for a specific activity. The

question regarding profit motive is initially triggered by history of losses. For this

reason, the development of this relevant factor provides the framework for this

section. Examiners should not base any conclusions using this relevant factor

alone.

Factor 7: The Amount of Occasional Profits, if Any, Which Are Earned

The examiner needs to address the amount of occasional profits that the taxpayer

has derived from the activity. In most instances where the provisions of IRC

section 183 are considered, the taxpayer will have few profits, if any.

Source of the Income

The examiner needs to consider whether the taxpayer has generated any profits

from the activity. A worksheet would be a useful tool in showing these profits or

the lack thereof.

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The examiner should pinpoint the exact source of the gross receipts reported on

the Schedule for the activity on the tax return. There have been instances where

taxpayers have misplaced gross receipts, which were derived from sources other

than the activity, onto the Schedule for the activity. The misplacement may be an

error, or it may be a deliberate attempt to show revenue where revenue did not

exist.

If the examiner determines that certain gross receipts were misplaced on the

activity’s Schedule, the examiner should not include these gross receipts in any of

the worksheets prepared for the purpose of developing the IRC section 183 issue.

If any worksheets are prepared with the omission of any such gross receipts, a

footnote should be included on each worksheet disclosing such omission.

Example 3

A Schedule F for a horse breeding activity contained gross receipts for $3,200.

Upon further development, the examiner discovered that the entire amount of

the gross receipts pertained to a separate activity, other than the horse breeding.

The examiner did not include the $3,200 of misplaced gross receipts in any

worksheets during the development of the IRC section 183 issue. The examiner

did incorporate footnotes that disclosed that $3,200 of gross receipts was

erroneously reported on the Schedule F.

If as in the aforementioned example, a significant sum of gross receipts was

misplaced on the activity’s Schedule and significant misrepresentation for the

profitability results, the examiner should consider the implications of such

misplacement. Civil fraud may be a consideration depending upon the overall

impact.

If the examiner in the previous example had not excluded the misplaced gross

receipts from the various IRC section 183 worksheets, then a true picture of the

taxpayer’s activity would not have been portrayed.

Some taxpayers have fabricated income for the activity in an effort to put forth an

appearance of profit motive. The examiner needs to verify the income. Such

fabrication raises consideration of potential fraud. Examiners should follow local

procedures in such instances.

Summary of Factor 7

The examiner should consider the amount of occasional profits that the activity

may generate. However, the examiner should determine the source of the gross

receipts just in case the gross receipts have been misplaced on the tax return.

Such misplacement could misstate the profitability of the activity and should be

removed from the IRC section 183 issue development with footnotes or

disclosures to that effect.

Factor 8: The Financial Status of the Taxpayer

This factor addresses the financial status of the taxpayer. In some instances, the

taxpayer may have the financial wherewithal to sustain a history of financial

losses for the activity. Certain taxpayers may receive a tax benefit from the losses

incurred by the activity as these losses will offset other substantial sources of

income.

Other Substantial Sources of Income

In general, taxpayers with other substantial sources of income have the financial

wherewithal to sustain significant losses from activities that appear to meet the

criteria of the provisions set forth under IRC section 183.

Taxpayer propaganda has been written that advises taxpayers to enter into horse

activities for the purpose of deriving a tax benefit. Some of the propaganda has

referred to such participation as “horse shelters.” There are no sections of the

Internal Revenue Code that address tax shelters for horse activities. The

propagandists have based their theory upon the language of IRC section 183 with

respect to horse activities and played within the gray areas to suit their purpose.

In general, horse activities are not inexpensive. Taxpayers with other substantial

sources of income have the financial wherewithal to enter such activities

irrespective of the motivation. The examiner needs to understand why the

taxpayer has not abandoned an unsuccessful activity when other taxpayers who

lack the same financial wherewithal would most likely abandon the unprofitable

activity.

Many Tax Court cases have been pursued which involve taxpayers that have other

substantial sources of income that have engaged in historically unprofitable horse

or cattle operations without abandonment. In general, taxpayers who have other

substantial sources of income have not faired as well in Tax Court litigation as

taxpayers who do not have such financial wherewithal.

Issue Identification

The examiner needs to document the financial status of the taxpayer in the

workpapers. The examiner should also make a statement to the effect that the

financial status has enabled the taxpayer to sustain a history of losses in the

activity.

Earlier text directed the examiner to prepare a tax savings benefit analysis. This

spreadsheet would show possible motivation for certain taxpayers to continue

participation in an unsuccessful financial endeavor.

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Summary of Factor 8

In general, taxpayers who have other substantial sources of income have the

financial wherewithal to sustain a history of losses with respect to cattle or horse

activities. Some taxpayers actually derive a tax benefit from participation in these

activities since the losses offset the other sources of substantial income.

Factor 9: The Elements of Personal Pleasure or Recreation

Section 183 has been referred to as the “hobby loss” section because many

taxpayers have engaged in unprofitable activities due to the pleasurable attributes

of the activities. Factor 9 addresses the elements of personal pleasure or

recreation of the activity.

Pleasurable or Recreational Aspects

The examiner must develop an understanding of the taxpayer’s activity. This

understanding must be documented in the workpapers. The examiner must

document all tasks that the taxpayer performs within the activity.

Some taxpayers will attempt to downplay any pleasurable aspects of the activity.

Some will attempt to portray the activity as laborious with emphasis placed on the

drudgery. These taxpayers know where the examination is leading. They will

emphasize the labor to clean or muck the stalls. The examiner needs to

understand that if these taxpayers care about their animals that any such task is a

labor of love or concern for the well being of the animal.

Many individuals who have not participated in horse or cattle operations readily

buy into the “drudgery concept” set forth by certain taxpayers. Individuals who

have participated in such activities put aside the drudgery concept because they

see the overall picture. These animals are loved so they receive loving care

regardless of the effort required.

The examiner should realize that cattle and horse activities provide numerous

opportunities for social outlets. Breed association field days and auctions provide

social interaction with other breeders. Breeders also find peace and solace from

watching their herd grazing in the pasture. The animals can be a source of beauty

to behold in an environment of peace and tranquility. Great pride and satisfaction

can be derived from the accomplishments achieved. Breeders enjoy watching the

new baby offspring romping and playing in the pastures.

Many taxpayers will express a passion for their activity. A skilled examiner will

be able to draw this passion from the taxpayer through conversation.

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The Internal Revenue Code does not mandate that taxpayers cannot enjoy the

method by which they derive their income. Many taxpayers resist the

phraseology of “hobby loss” in reference to IRC section 183. As previously

mentioned, examiners may wish to refrain from that terminology and refer to the

actual title “Activity Not Engaged in for Profit.”

Issue Identification

The examiner needs to listen carefully to the taxpayer’s discussion of the activity.

Both cattle and horse activities provide opportunities for social interaction with

other breeders or participants. The thrill of competition draws participants into

various shows and competitive events. A sense of accomplishment attracts

participants to compete in events where there may not be any monetary

compensation for their efforts. Great pride accompanies the receipt of large

trophies and fancy rosette ribbons and award banners.

Summary of Factor 9

The examiner needs to address the pleasurable and recreational aspects of the

activity. The examiner should remember that taxpayers are willing to overlook

the drudgery of certain tasks when the pleasurable aspects outweigh the negatives.

An individual who loves his or her animals will willingly provide loving care.

By this point in the examination, the taxpayer is aware of the direction that the

exam is going. The taxpayer knows about the nine relevant factors. A taxpayer

with a savvy representative has been advised to downplay the pleasurable aspects

and emphasize the drudgery and dirty work of the activity. Skilled listening will

help the examiner to document and sort the details regarding this relevant factor.

COMPLIANCE ISSUES

Unique compliance issues will be discussed. Where applicable, information will

be included on these areas of noncompliance:

• Underreporting of income

• Employment taxes

• IRP document compliance

• Misplaced income sources

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Underreporting of Income

Incomplete books and records may lead to the underreporting of income. Sales

Invoices from the sale barn may not be retained in a manner to facilitate correct

income computations. Checks from the sale barn for the sale of cull animals may

be de minimis in dollar value. These inconsequential checks are frequently not

deposited into bank accounts, but are cashed. Small cull sales may be significant

in the aggregate. The examiner may need to engage an indirect method to reveal

unreported sales.

The examiner should be aware that sale barns are not currently required to issue

Forms 1099 for horse and cattle sales.

One indirect method could be based on the herd inventory where every available

producing animal and resulting offspring are counted. Another indirect method

could be developed from the Feed Expense. The examiner could project the

number of animals fed based upon checking the feed consumption. The local

Agricultural Extension Agent can provide formulas that consider the annual feed

consumption of an animal. This formula will enable the examiner to project feed

costs over the entire herd. The examiner should consider the facts and

circumstances of the taxpayer in determining whether all gross income has been

correctly reported and developing alternative methods in the instances where

gross income may be understated.

Employment Taxes

Many of the taxpayers who potentially fall under the provisions of IRC section

183 are involved in business ventures other than the horse activity or cattle

operation. In fact, these taxpayers may derive a substantial amount of income

from these ventures and devote a great deal of time to the primary sources of their

income. As a result, third parties are engaged to perform the labor for the horse

and cattle activities. Depending on the locale of the horse or cattle activity,

undocumented laborers may be used. Other employment tax issues may result

from failure to file Forms 1099. Employee classification issues may also be

present.

IRP Document Compliance

The taxpayer may fail to report all sources of income per reconciliation of the IRP

document. Such failure may be deliberate or the result of incomplete records.

The taxpayer may also miscategorize income derived from another source on the

Schedule for the horse or cattle activity in an effort to show income for that

activity.

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Misplaced Income Sources

As mentioned in the previous paragraph, taxpayers may misplace income sources

in an effort to show income for the horse or cattle activity. This may or may not

result in a net profit for the activity.

The examiner needs to examine the compilation of reported gross receipts for the

activity. Misplaced income items may need to be moved to the correct schedule

in order to achieve the appropriate tax treatment for the transaction.

The examiner also needs to consider the implications of any misplaced income

items, especially when the impact is significant.

Example 4

Income derived from working at a florist shop was placed on the Schedule for a

horse activity. The horse activity had no other sources of income. As a result,

the horse activity appeared to be generating income.

This discussion of issues is not all-inclusive. Examiners should be aware of new

and emerging issues within the horse and cattle industries. Local MSSP

Specialists can assist examiners with changing trends.

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Chapter 3

Examination Techniques

PURPOSE

This chapter covers the techniques specific to examining the issues identified in

the previous chapter.

The development of the IRC section 183 issue is a fact-gathering process. The

Treasury Regulations provide further guidance through nine relevant factors. In

order to adequately develop IRC section 183, the examiner needs to address the

nine relevant factors during the Initial Interview. The Regulations indicate that no

single factor determines whether the activity is engaged in for profit. The

examiner needs to consider all of the factors and draw a conclusion based upon

the examiner's professional judgment.

In addition to the nine relevant factors, the examiner also needs to develop a full

understanding of the taxpayer's activity and the extent of the taxpayer's

involvement in the activity. It is not enough for the examiner to know that a

taxpayer is involved in a horse activity or cattle operation. The examiner needs to

understand what specific type of horse activity or cattle operation the taxpayer is

engaged.

INFORMATION DOCUMENT REQUEST (IDR)

Shown below are some documents examiners may want to consider when

preparing an Information Document Request (IDR). Not all of these items should

be requested in every case. Not all items would be requested on the first IDR.

Some items may be appropriately requested on a subsequent IDR. Examiners

should use this information as a guide and request only the items that are

appropriate and relevant for their specific case:

• Registration certificates for animals, if applicable

• A copy of the herd inventory for the year of examination

• Supporting documentation for all expenses deducted on Schedule C/F

• Business plan for activity

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Issue Identification

Reviewing the tax return will provide the first issues for further development by

the examiner. These issues would include any large, unusual, or questionable

(LUQ) items contained on the Schedule pertaining to the activity. These LUQ

items would be addressed during the Initial Interview and the Information

Document Request.

When considering LUQ items, the examiner needs to inspect the relationship of

any showing expenses to the overall Schedule C or F. A significant amount of

showing and showing-related expenses could be indicative of an activity not

engaged in for profit if the prizes are minimal in financial remuneration. The

examiner needs to determine the specific purpose for which the taxpayer

participates in show competitions. The examiner needs to determine if the show

winnings justify the showing expenses. If the taxpayer’s activity is a showing

activity, then all of the expenses would be related to showing. If the taxpayer’s

showing activity is not generating sufficient prize money, then the profit motive

should be considered.

The examiner should consider the gross receipts for the activity. The tax return

may have minimal or zero gross receipts. The activity’s history of gross receipts

should be addressed. The examiner needs to determine why there have been

minimal or no gross receipts. The examiner needs to determine specifically when

the taxpayer expects for gross receipts to increase and specifically how the

taxpayer expects to accomplish this.

Examiners need to verify all expenses that pertain to the activity’s Schedule C or

F. The examiner needs to prepare a worksheet which details any personal

expenses contained within these Schedules. The worksheet should detail whether

the expenses were fully substantiated. This worksheet would be necessary if the

case should close “unagreed” at the Group level. The information would be

useful in preparing alternative positions.

Using Specialists and Other Resources

Specialists and other outside resources can provide assistance in developing IRC

section 183 issues. These specialists can come from within the Internal Revenue

Service or from outside of the organization.

IRS specialists could include farming industry specialists, Market Segment

Specialty Program agents or Economists. Industry specialist and MSSP agents

would be able to provide insight regarding industry specifics. Economists would

be able to provide guidance regarding the economic feasibility of the taxpayer’s

business plans. District economists may be formally assigned to a specific case or

the examiner may informally contact them.

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The current Internal Revenue Code dictates that the taxpayer must be notified

prior to the examiner’s contact of third parties. This notification is required if the

examiner should ask specific questions about specific taxpayers. If the examiner

should choose to ask a generic question which does not pertain to a specific

taxpayer by name, then this notification process is not required. For example, the

examiner could inquire of an Agricultural Cooperative Extension Agent as to the

recommended number of cattle per acre for a certain county. This inquiry does

not identify a specific taxpayer by name. Furthermore, the examiner could gather

breed information from a breed association’s Web site on the Internet (in

District’s where such access is available). These requests do not fall under the

notification guidelines.

In the Districts where Internet access is available, the Internet can also serve as

another resource for information. The examiner can obtain general information

about the taxpayer’s breed of cattle or horse from the breed association’s Web

page. Some taxpayers may have a Web Site for their activity.

INITIAL INTERVIEW

A sample questionnaire has been provided in the Appendix. This questionnaire is

comprised of questions to consider asking at the Initial Interview. Not all of these

questions are warranted in every case. Examiners should use them as a guide and

ask only those questions that are appropriate for the specific examination. Some

questions pertain only to horse activities while others pertain only to cattle

operations.

The examiner should note that the sample Initial Interview contains questions that

are pertinent for certain methods of conducting these activities. For example,

some questions are specifically directed to commercial cattle operations while

other questions are specifically directed to herds registered with a recognized

breed association.

The examiner should request the taxpayer’s presence for the Initial Interview

because the Power of Attorney generally will not have intimate knowledge of the

taxpayer’s method of operation. While some Powers of Attorney will try to

handle the Initial Interview without the taxpayer’s presence, the taxpayer is the

best resource regarding the activity. The Initial Interview should contain very

specific questions regarding the activity.

If a Power of Attorney attempts to conduct the Initial Interview without the

taxpayer present, do not accept responses from the POA which appear to be

“guesses.” Some answers may appear to be “canned” or broadly unspecific to the

examiner’s taxpayer. These “guesses” and “canned responses” will not serve the

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taxpayer fairly. At such a point, the examiner should ask the Power of Attorney

to reconsider the taxpayer’s participation for the meeting.

During the Initial Interview, the examiner should discuss the taxpayer’s Business

Plan for the activity. Do not request the Business Plan on the Information

Document Request with the first appointment letter or the examiner will receive a

“canned document.” The examiner wants to develop candid and spontaneous

responses from the taxpayer during the Initial Interview. The formal Business

Plan should be requested on a subsequent Information Document Request. If the

taxpayer indicates that no formal written Business Plan exists, or has ever existed,

the examiner must document this fact in the interview workpapers.

Refer to the Issues chapter for a full discussion of the formal Business Plan.

Sample Initial Interview questions will be listed in the Appendix. These

questions can provide a reference; however, the examiner will want to customize

the questions to suit the specific taxpayer.

The Initial Interview should gather detailed information about the taxpayer’s

activity. The examiner should not generalize all taxpayers that participate in

horse activities or cattle operations. Each taxpayer conducts his or her respective

activity differently from others in the same activity. The Initial Interview should

document and detail specific information.

EXAM LOCATION AND BUSINESS TOUR

There are special aspects of the market segment that need to be observed during

the tour of the business facility. These observations will be made in correlation

with the nine relevant factors set forth in the Treasury Regulations for IRC section

183.

Tour of Operation

Tours of the taxpayer's operation can be a very helpful tool in the examination

process. Tours can help the examiner develop an understanding as to the

operation of the activity since methodology could vary. Assumptions about

activities should never be made because each taxpayer could operate differently.

The examiner should be aware that a tour of the operation could possibly impair

the examiner's perception of the taxpayer's level of expertise. For example, if the

taxpayer’s expertise regarding the activity exceeds the examiner's expertise in the

same activity, the examiner could incorrectly conclude that the taxpayer has met

Factor 2 of the nine relevant factors in the Regulations. That aspect will be

discussed further later in the text.

Prior to the tour of the operation, the examiner should decide whether the

assistance of an IRS Farm Specialist would be beneficial. This decision would be

based upon the examiner's comfort level with the taxpayer’s activity. An IRS

Farming Specialist could attend the tour of operation with the examiner. Upon

the conclusion of the tour, the specialist could provide the examiner with

recommendations for further development of the IRC section 183 issue. The

specialist would also provide another professional opinion as to the presence of

the issue.

The examiner should make note of the overall first impression of the activity’s

facility. The examiner should observe the condition of the structures and fences.

Are they in good condition or disrepair? Will the condition of the structures and

fences serve the purpose intended? Would any animals be able to escape from the

fenced-in area? Could the animals become harmed due to the inadequacy of the

structures or fences?

The examiner should not let the presence of fancy buildings, barns, and expensive

fence influence an opinion regarding the profit motive of the activity. Expensive

barns, fences, and equipment do not automatically equate to a business engaged in

for profit. Such items, when purchased for a hobby activity, are indicative of the

taxpayer’s affluent taste and preferences, not profit motivation.

In addition to the first impression of the activity's facilities, the examiner should

exercise professional judgment and ascertain the taxpayer’s familiarity of the

facilities. This determination can be made if the taxpayer is present for the tour.

The taxpayer's familiarity could be an indicator of the level of participation within

the activity. The taxpayer's knowledge and expertise, or lack thereof, could

become evident during the tour.

The examiner needs to be careful not to be influenced by the taxpayer’s

knowledge or expertise merely because that knowledge or expertise exceeds that

of the examiner's. While many taxpayers may have basic knowledge requisite of

that particular activity, the basic knowledge does not equate to a profit motivation

nor does it demonstrate that the taxpayer has the knowledge or ability to operate

the activity like a business with a profit motive. Many hobbyists possess a wealth

of knowledge regarding their activities.

Furthermore, the taxpayer may indeed possess basic knowledge of the activity and

yet proceed to exercise some very poor decisions with respect to that activity.

Some decisions might be so poor that other taxpayers within the same activity

would consider those decisions extremely inappropriate and incorrect.

Example 1

taxpayer states that he sold his entire herd of registered cattle so that he could

start over with a commercial cattle herd. Upon the complete dispersal of the

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registered animals, the taxpayer purchased commercial grade cattle. The cattle

were fully depreciated. That decision was inappropriate and incorrect. If the

taxpayer had stopped registering the offspring with the breed association, then

the taxpayer would have turned his herd into a commercial cattle herd. The

taxpayer did not need to disperse an entire herd in order to accomplish the goal

of attaining a commercial herd.

The aforementioned example serves to show that taxpayers may exercise

inappropriate decisions in spite of the basic knowledge possessed. Examiners

should not be intimidated if the taxpayer's knowledge exceeds their own.

Furthermore, examiners should not prematurely conclude that the taxpayer is

engaging in the activity for the sake of a profit just because the taxpayer possesses

knowledge of the activity.

The examiner should be aware that taxpayers could make preparations for the tour

of operation that would result in a misrepresentation of the activity.

Example 2

A taxpayer that does not really maintain a certain number of cattle could have

cattle trucked to the location for the purpose of the examiner's tour. Such cattle

in this scenario would probably not belong to the taxpayer or the taxpayer may

have recently purchased these animals at the sale barn for the purpose of the

operation tour.

Example 3

An Appeals Officer viewed videotape of the taxpayer’s beef cattle operation.

The Appeals Officer observed that the cattle in the video were Holstein dairy

cows and not the taxpayer’s designated beef breed. The taxpayer decided to

concede the IRC section 183 issue after that point.

The examiner should be alert that cattle could be shipped in for the examiner's

tour. An examiner should look at the cattle to determine if the eartags follow the

taxpayer’s herd inventory. The examiner should cross match the herd inventory

and attempt to locate a sample from within the herd. If the examiner cannot

locate any animals from the sample, then the sample should be expanded. The

examiner should inquire where these animals are located. The examiner should

exercise professional judgment if it becomes apparent that the herd inventory does

not tie to the physical inventory in the pasture. Death could account for some

missing cattle. The examiner should consider the impact if the cattle have been

misrepresented.

When the examiner views the livestock, the examiner should observe whether the

animals are readily identifiable and distinguishable from one another through the

use of eartags or other similar markings. The presence of a brand on the animals

serves to identify ownership of the livestock. If the animals were acquired from

another breeder, then the brand of the original owner might still be on the animals.

The eartags would serve to identify the individual animal from all other animals

in the herd and permit the taxpayer to maintain performance records on each

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individual animal. The numbers on the eartags should be separate and distinct. In

other words, the herd should not contain two animals with the same ear number.

The examiner may wish to sample eartag numbers to test the taxpayer's

recordkeeping. The examiner could ask to review the performance records of

those animals sampled. The significance of performance records will be

discussed in greater detail later in the text.

In addition to the observation of eartags, the examiner should also observe how

many breeding males are present within the herd. Purebred associations mandate

that the breeding females should only be exposed to one breeding male at any one

time. This regulation ensures that the true parentage of any offspring is known to

be correct and guarantees the accuracy of that offspring's pedigree for registration

purposes.

With respect to commercial herds (where the offspring are not registered through

a recognized breed association), the taxpayer should still refrain from exposing

the breeding females to more than one breeding male at any one time. The

taxpayer needs to know with certainty which breeding male has sired each

offspring in order to evaluate the performance of each breeding male. Breeding

males need to be removed from the breeding program if that particular breeding

male is not producing desirable offspring.

The taxpayer may argue that he or she can determine which breeding male sired

which offspring based upon the color of the offspring. This defense is not

genetically valid. For example, the taxpayer may have one black stud and one red

stud. The females may be of any color. If the taxpayer releases both studs into

the herd at the same time, the color of the resulting offspring cannot be used to

determine paternity because of the color genetics present in the females' ancestry.

The red stud may still produce a black offspring if there was any black in the

female's ancestry. If perhaps the red stud had black in his ancestry, then resulting

offspring could be of either color.

During the course of the tour, the examiner should make notes of the observations

as well as questions for further follow-up. Some examiners may wish to take

photographs with the permission of the taxpayer.

The examiner should observe the condition under which the taxpayer stores the

hay for the livestock. If the taxpayer does not adhere to local suggested methods,

the examiner should consider the taxpayer's knowledge or expertise. Perhaps the

taxpayer's use of unsuitable methods is an indication of the taxpayer's lack of

concern for the activity’s profitability. The examiner should consult with local

agricultural specialists for recommended methods. In general, hay should be

stored in such a way that it does not get wet and mold. While large, round bales

may be maintained in the fields, they should be covered with some type of fabric

covering to protect from moisture. Spoiled hay could present health problems for

the animals. Cattle are less at risk, but horses can develop colic and die from poor

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quality hay. Poor quality hay is low in nutritive value, which would result in poor

growth of the animal consuming such hay. Poor growth results in more cost for

the taxpayer in order to achieve market weights for cattle. Increased costs reduce

the overall profit for the activity.

The examiner should observe the physical condition of the taxpayer’s animals.

The examiner should consider whether the animals appear to be well fed or

underfed. The technical process of assessing an animal’s flesh condition is

sometimes referred to as body scoring. Local cooperative agricultural extension

agents can provide guidance as to how body scoring is determined for both horses

and cattle. The examiner will probably not need to compute condition scores

during the examination process. Nonetheless, the examiner needs to comment as

to the overall flesh condition. Flesh condition and condition scores have been

proven indicators of an animal's reproductive abilities. Impaired reproductive

abilities reduce the activity's profitability if breeding is a component of the

activity. In other words, animals that receive poor nutrition are less capable of

successful reproduction and impaired reproduction affects the activity’s bottom

line.

The animal's body condition should be considered as an indication of the

taxpayer’s involvement in the activity. An absentee owner may not be aware of

the care that an animal is receiving. There have been several incidents whereby

absentee owners have neglected their livestock and the animals have been known

to starve to death. Some livestock have contracted an illness or disease of which

the absentee owner was not aware. Lack of timely medical intervention has

resulted in death. These occurrences do not mean that every absentee owner

neglects his or her livestock. In fact, the absentee owner may have hired a

competent manager. The hired manager may or may not be competent or reliable.

The absentee owner should stay on top of the activity and intervene when the

hired manager fails to adequately perform his or her duties. Absentee ownership,

as it lends to an alternative position for passive activity, will be discussed in

greater detail later in the text.

Alternatives to Operation Tours for Tax Auditors

Tax Auditors do not have the opportunity to perform a physical tour of the

taxpayer’s activity. However, the Tax Auditor can inspect any photographs that

the taxpayer may have of the facility or of any animals owned by the taxpayer.

The Tax Auditor will have to use professional judgment in gauging the

authenticity of the photographs. Remember that the photographs are going to

reflect the best side of the activity. Any unflattering photographs will not be

shown to the Tax Auditor.

Tax Auditors will find Agricultural Cooperative Extension Agents very helpful

resources. These County Agents can tell the Tax Auditors how many animals per

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acre should be carried in a particular area of a specific county. The Tax Auditor

can then determine if the taxpayer has sufficient land in order to carry the

requisite animals needed to generate adequate revenue.

Tax Auditors can also consult with any district Revenue Agent who may

specialize in the farming issues. If circumstances warrant, perhaps a District

MSSP Specialist could perform the operation tour and report back to the Tax

Auditor.

The Tax Auditor will rely upon interviewing skills in order to develop the facts.

Since IRC section 183 cases are fact gathering intensive, Tax Auditors are not

completely hindered even though they cannot perform field tours.

UNIQUE INDIRECT METHODS

The development of IRC section 183 Farm Hobby Loss cases could use Indirect

Methods for certain aspects of case development. A discussion of unique indirect

methods follows. This includes creative methodologies developed for the market

segment such as:

• Gross-up on feed purchases

• Potential sales based upon breeding herd inventory

The use of financial status audit techniques should be limited to situations where

the IRS already has indications of unreported income.

BOOKS AND RECORDS

Horse activities and cattle operations have unique methods of recordkeeping

which serve to track the performance of each animal. These records should be

used as management tools to enable the taxpayer to make informed business

decisions.

SOURCES OF INFORMATION

There are numerous sources of information about horse activities and cattle

operations. These include:

• Breed associations

• Memberships in cattle and horse associations other than breed associations

• Local County Agricultural Extension Agents

• Other ATGs and reference material (Internal Revenue Service publications,

periodicals, etc.).

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OTHER

The examiner may need to use a summons in order to obtain corroborating

information from third parties. The examiner will need to refer to current local

procedures for third party notification.

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Chapter 4

Supporting Law

PURPOSE

This chapter provides the examiner with the legal support for the issues including:

• Internal Revenue Code

• Treasury Regulations

• Court Cases

• Coordinated Issue Papers

INTERNAL REVENUE CODE

Internal Revenue Code section 183 provides guidance.

The general rule under IRC section 183 states that “in the case of an activity

engaged in by an individual or an S Corporation, if such activity is not engaged in

for profit, no deduction attributable to such activity shall be allowed under this

chapter except as provided in this section".

This section does not apply to C Corporations.

IRC section 183(c) defines an activity not engaged in for profit as any activity

other than one with respect to which deductions are allowable for the taxable year

under IRC section 162 or under paragraph (1) or (2) of IRC section 212. In other

words, this section refers to an activity to which deductions are not deductible

under IRC section 162 or under paragraph (1) or (2) of IRC section 212.

IRC section 183(d) defines the presumption that addresses the number of years for

which an entity should observe a profit during a period of consecutive taxable

years. For the purpose of this text, cattle operations must observe a profit for 3 or

more taxable years during a period of 5 consecutive taxable years. Horse

activities such as breeding, training, showing, or racing must observe a profit in 2

of 7 consecutive taxable years.

TREASURY REGULATIONS

Treasury Regulation section 1.183-(2)(b)(1) through (9) provides guidance

through nine relevant factors for consideration of the applicability of IRC section

183. All nine factors must be considered when determining if an activity is

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engaged in for profit. No one factor is determinative; however, the more factors

in the Government’s favor, the better. The nine relevant factors will be discussed

in the following summary. Refer to the Issues chapter for greater development of

the factors.

Activity Not Engaged In For Profit

Treasury Regulation section 1.183-2(b)(1) through (9)

1) Manner in which the taxpayer carries on the activity.

The fact that the taxpayer carries on the activity in a businesslike manner

may indicate that the activity may be engaged in for profit. Determine

whether the taxpayer maintains complete and accurate books and records.

Changes in operating methods, adoption of new techniques, and

abandonment of unprofitable methods may also indicate a profit motive.

It should be noted whether the taxpayer actually uses these books and records

as a management tool whereby decisions regarding the activity are made

from these records.

2) The expertise of the taxpayer or his advisors.

Preparation for the activity through extensive study of accepted business,

economic, and scientific practices, or consultation with experts may indicate

that the taxpayer has a profit motive where the taxpayer adheres to such

practices.

The examiner should also denote specific instances where the taxpayer has

not followed the recommendations of his advisors and why.

3) The time and effort expended by the taxpayer in carrying on the activity.

The fact that the taxpayer devotes much of his personal time and effort to

carrying on the activity, particularly if the activity does not have much

substantial personal or recreational aspects, may indicate an intention to

derive a profit.

4) Expectation that assets used in the activity may appreciate in value.

The term “profit” encompasses appreciation in the value of assets used in the

activity. Thus, the taxpayer may intend to derive a profit from the operation

of the activity when appreciation in the value of the assets used in the activity

exceeds operation expenses.

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Taxpayer’s goal: Show that the activity and the holding of the asset = single

activity.

Examiner’s goal: Show that the activity and the holding of the asset =

separate activities.

Why?

Single activity – The taxpayer may offset the potential gain from the sale of

assets against the history of losses. Examiners should utilize land

comparables to verify potential appreciation.

Separate activities – The taxpayer cannot offset the history of losses against

the potential appreciation.

How?

The examiner begins with the Schedule F (C) and removes any expenses

associated with the carrying costs of the land, such as taxes and mortgage

interest. Only current operating costs should be remaining. Determine

whether Gross Receipts exceeds the current operating costs. If current

operations generate a net profit, then the holding of the land and the

operation of the activity are considered to be a single activity. If Gross

Receipts do not exceed current operating costs and a net loss is derived, then

the holding of the land and the activity are considered to be separate

activities.

5) The success of the taxpayer in other similar/dissimilar activities.

The fact that the taxpayer has engaged in similar activities in the past and

converted these activities from unprofitable to profitable enterprises may

indicate that the taxpayer has engaged in the present activity for profit,

regardless of current profitability.

However, the examiner should address why the taxpayer, who has been

capable of financial success with other endeavors, can suffer a history of

losses and lack of financial success with the activity under consideration.

Furthermore, the examiner should consider why the taxpayer has not

abandoned the activity in spite of historical losses.

For example, a business executive has derived financial success from several

business ventures. However, his horse activity has continuously generated

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significant net losses. The examiner should address why an executive, who

possesses the business savvy to generate substantial profits from other

ventures, has been unable to generate a profit from the activity under

consideration.

6) The taxpayer’s history of income or losses with respect to the activity.

A series of losses during the initial start-up of any activity may not

necessarily be an indication that the activity is not engaged in for profit.

However, when losses continue to be sustained beyond the normal start-up

period, such losses may be an indication that the activity is not engaged in for

profit.

If the losses were sustained due to unforeseen or fortuitous circumstances,

such losses would not be indication that the activity is not engaged in for

profit. Fortuitous circumstances may include depressed market conditions.

The examiner should consider whether the taxpayer has made any

concessions to change his business plan and marketing strategy in times of a

depressed market.

7) The amount of occasional profits, if any, which are earned.

The opportunity to earn a substantial profit in a highly speculative venture

may be sufficient to indicate that the activity is engaged in for profit. The

examiner should ascertain whether the taxpayer performed any significant

investigative work prior to the commencement of the activity. Refer to

Factor One.

8) The financial status of the taxpayer.

Substantial income from other sources may indicate that the activity is not

engaged in for profit, especially if there are personal or recreational elements

involved. The taxpayer may also derive a tax benefit from any losses

generated from the activity. Some taxpayers with affluent lifestyles enjoy

participating in certain activities, such as horse breading, and have the

financial wherewithal to do so.

9) Elements of personal pleasure or recreation.

The presence of personal motives in carrying on an activity may indicate that

the activity is not engaged in for profit. This may be especially true when

there are recreational or personal elements involved. The Internal Revenue

Code does not preclude the taxpayer from enjoying the activity in which he is

engaged. However, the taxpayer should not allow personal pleasure or

recreation to prevent abandonment of an otherwise unprofitable activity.

CASE LAW

There are innumerable United States Tax Court cases for IRC section 183 Farm

Hobby Losses. Some cases have been favorable for the taxpayer while other

cases have supported the Government. The volume would extend beyond the

breadth of this text.

The examiner should cite cases on point that have specific facts that match the

facts of the taxpayer currently under examination. The examiner should also note

unfavorable cases to the Government on which the taxpayer may rely. The

examiner should request that the Power of Attorney provide a list of the cites of

court cases which defend the taxpayer’s position.

COORDINATED ISSUE PAPER

At the time of this writing, there are not any Coordinated Issue Papers for this

market segment.

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CALCULATING THE EXAMINATION ADJUSTMENT PER IRC section 183

When the examiner has determined that the taxpayer falls under the provisions of

IRC section 183, the section provides guidance in calculating the examination

adjustment using an ordering principle.

The actual adjustments have been frequently computed incorrectly. This portion

of the text will lead the examiner through the correct calculation.

INCORRECT COMPUTATION OF ADJUSTMENT

A common error in computing the IRC section 183 adjustment involves a

simplistic approach, which makes logical sense, but is incorrect nonetheless.

Examiners have started with Gross Receipts and deducted expenses to the extent

of Gross Receipts using the ordering principle; however, examiners have

frequently failed to move Mortgage Interest, Real Estate taxes, and casualty

expenses over to Schedule A subject to AGI limitations.

The following example shows the incorrect method of computation. Examiners

should not use this method of computation!

Gross Receipts 5,400.00

- Expenses (Mortgage Interest) 4,800.00

- Expenses (Supplies, Repairs, Etc.) 600.00

= Balance of Gross Receipts 0.00

Remaining Expenses = Adjustment 24,000.00

ORDERING PRINCIPLE

Treasury Regulation section 1.183-1(b)(i) through (iii) provides guidance using

the ordering principle with respect to allowable deductions.

Begin with the activity’s Gross Receipts for the current taxable year. Allowable

deductions will not exceed the Gross Receipts for the activity.

The Treasury Regulations allow expenses to be deducted in the following order:

1. Mortgage interest, taxes, and casualty losses.

2. Expenses that do not reduce basis such as Supplies, Utilities, and other such

expenses.

3. Depreciation and amortization expenses.

It should be noted that other sections of the Internal Revenue Code might also be

applicable during the ordering process and further limit the deductibility of certain

expenses. For example, Interest Expense may be further limited under IRC

section 163(d).

The examiner needs to evaluate the expenses deducted on the Schedule C or F and

place these expenses in the aforementioned order. A separate worksheet is

helpful in preparing the adjustment.

MORTGAGE INTEREST AND REAL ESTATE TAXES

Mortgage interest, real estate taxes, and casualty losses top the list because these

items would be deductible elsewhere on the tax return. Since these items are

deductible elsewhere, the examiner’s first step is to move these expenses over to

Schedule A, deductible subject to the limitations of AGI phaseout.

DEDUCTIONS TO THE EXTENT OF GROSS RECEIPTS

The amount of expenses moved to Schedule A are deducted from Gross Receipts

that may or may not fully absorb Gross Receipts. If any portion of Gross Receipts

remains for absorption, then the examiner will allow a deduction for expenses

which do not reduce basis, such as Supplies, Utilities, and so forth. These

expenses are generally current expenses for the activity.

If any Gross Receipts are left for absorption after the deduction of the

aforementioned expenses, then the examiner will allow the deduction for

Depreciation and amortization expenses.

In most instances, Gross Receipts are not adequate for the deduction of all

expenses as deducted per return. To the extent that the expenses exceed Gross

Receipts, an adjustment is made to disallow the extra expenses.

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Appendix B

ALTERNATIVE POSITIONS

It is always prudent for an examiner to be prepared to present an Alternative

Position with any unagreed report. IRC section 183 positions are no exception.

There are several viable alternative positions that are companions to the IRC

section 183 position. IRC section 162 Business Expenses should be addressed in

all IRC section 183 cases. Section 469 for Passive Activity Losses may be

applicable to the taxpayer at hand.

Many times the IRC section 162 alternative issue is not fully developed. The

examiner should first substantiate the income and expenses. Then the examiner

should make a determination regarding ordinary and necessary with respect to the

expense items.

Depreciation Expense may require some significant overhaul depending upon the

taxpayer’s intent for the animals used in the activity. Many errors have been

incurred within the proper tax treatment of the animals. Previous text addressed

problems with this issue.

LEGAL PRESUMPTION

An activity shall be presumed to be engaged in for profit if the gross income

derived from the activity for three (or two if applicable*) or more of the taxable

years in such period exceeds the deductions attributable to the activity.

* Note: In the case of an activity that consists of breeding, training, showing, or

racing of horses, the activity shall be presumed to be engaged in for profit if the

gross income derived from the activity for two or more of the taxable years in

such period exceeds the deductions attributable to the activity.

The legal presumption serves to shift the burden of proof from the taxpayer to the

Government.

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Appendix C

GENERAL SUSPENSE AND

IRC SECTION 183(e) PROCEDURES

The taxpayer may elect to postpone a determination of whether or not an activity is

engaged in for profit. An individual taxpayer, S Corporation, trust or estate can make the

election. This election is initiated by the taxpayer. The postponement moves the

determination to the end of the fourth taxable year for cattle operations and to the end of

the sixth taxable year for horse breeding activities following the year when the taxpayer

first engages in a particular activity. In other words, the maximum postponement period

is five years from the year of inception for most activities and seven years in the case of

horse breeding, training, showing, or racing.

The election must be filed no later than the earlier of:

• Three years after initial statutory due date of the activity’s first year’s return, or;

• Sixty days after the taxpayer receives a written notice from a District Director that

proposes to disallow the deduction attributable to that activity because the activity is

not for profit.

IRC SECTION 183(e) SUSPENSE CASES

IRC section 183(e) and Treas. Reg. section 12.9 sets forth guidelines for the taxpayer’s

election to postpone a determination with respect to the presumption described in IRC

section 183(d).

Form 5213 will be included in the case file. A copy of the form will be included in the

file when received by the examiner or the taxpayer will submit the original during the

examination.

If the taxpayer has not already submitted a Form 5213, the examiner should inform the

taxpayer of IRC section 183(e) provisions if the Statute of Limitations has not expired for

the activity’s first return.

The examiner should verify that the Form 5213 has been timely filed.

The examiner needs to refer to local District procedures for further information regarding

case processing and closing under IRC section 183(e) provisions.

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Appendix D

INITIAL INTERVIEW

RELATED TO CATTLE AND HORSE ACTIVITIES

1. Describe the activity engaged in on the Schedule.

2. What is your (taxpayer’s) background in the activity? (Include # years, any formal training, practical

experience)

3. Do you have others (employees, trainers, consultants, etc.) involved in the activity? (Include names)

4. On what criteria were the other individuals selected and by whom? (Detail any professional

credentials)

5. What is the level of experience and expertise of these individuals? (Include # years, formal training,

practical experience)

6. With respect to the activity, how much time do you devote on a daily basis? Weekly basis?

7. How much time is devoted by any other individuals on a daily basis? Weekly basis?

8. How much direction do the other individuals receive with respect to their expected performance of

their duties?

9. What is the actual authority of these individuals?

10. What is the perceived authority of these individuals? (In other words, what authority would third

parties perceive these individuals to have?)

11. To what level do these individuals exercise their own judgment with respect to their duties?

12. How did the activity get started?

13. How long has the taxpayer engaged in the activity?

14. How was the activity financed? (gift, inheritance, loan, or cash)

15. Why was this activity selected for venture? Describe any investigation.

16. What has made the activity to be historically unprofitable? Provide specific dates and describe any

unforeseen circumstances.

17. What specific measures and changes have been implemented to reduce costs and increase profitability.

18. Are any assets expected to increase in value? List specific assets.

19. What is the basis for any expectation for increased value of certain assets? (Has taxpayer provided any

written real estate comparables?)

20. Describe the success of other ventures or the lack thereof.

21. How many acres are involved with this activity? (Distinguish between owned and leased)

22. From whom is any acreage leased?

23. How is the acreage being utilized?

24. How many animals are using this acreage? (Calculate number and type of animal per acre)

25. What type of grass is present in the pastures?

26. Describe any pasture improvements. (Include any fertilizers, pesticides, herbicides, mowing,

excavation, installation of any ponds or other watering reservoirs)

27. Was anyone consulted regarding these improvement decisions? (Include specific names)

28. Who completed these improvements? For how much?

29. Why were these improvements implemented?

30. Describe any plans for future improvements.

31. How will these improvements be financed?

32. How is the acreage partitioned into pastures and what is the significance and use of these pastures?

33. How are the pastures used and rotated (if rotated)?

34. Are you growing any crops for feed to the livestock? (list specific items such as hay or grain)

35. Have you purchased any hay or feed when your own hay or grain was depleted?

36. Describe any custom hire (machine or labor).

37. List any other hired workers. Were any Forms 1099 required to be filed?

LIVESTOCK BREEDING PROGRAM:

38. What type of livestock is being raised? How many?

39. Who selects the animals for the breeding program?

40. What criteria are used for this selection?

41. What type of animal are you breeding for?

42. Is this a registered herd with a recognized breed association? Name the breed association.

43. How long have you been a member of the breed association?

44. How many animals are registered annually?

45. What criteria are used to select animals for culling?

46. If not a registered herd but a commercial herd, what breed(s) are used in the program?

47. How many breeding females are in the program?

48. How many breeding males are in the program?

49. Do you own the studs or do you use artificial insemination?

50. How do you select the sires for the program?

51. What kind of maintenance program do you use for the breeding males?

52. How many breeding males are exposed to the females at any one time? (Examiner note: Only one

male should be with the females at any one time in order to maintain accurate performance and

breeding records).

53. Do you use artificial insemination?

54. Who performs the artificial insemination?

55. Describe the method of recordkeeping that is in place for the breeding program.

56. Does this recordkeeping system track the live births, birth weights, weaning weights, service sires?

57. At what age are the offspring weaned? Describe the weaning process.

58. How are the offspring disposed? Are any used for replacements in the herd? Sold as feeders? Sold as

registered stock?

59. Are any of the animals showed at any livestock shows and competitions? Frequency?

60. How are the showing expenses treated within the books and records as well as the tax return?

61. What awards and honors have been received with respect to the showing?

COMMERCIAL BREEDING PROGRAM:

62. What breeds are used within the herd? Why?

63. Describe the feeding program? (Include percentage of protein, any supplements, so forth)

64. Are there any records which track weaning weights, daily rate-of-gain for the feedlot animals?

65. When are the animals weighed?

66. At what age or weight are the animals sold?

67. How many animals are sold annually?

68. Are any females retained as replacements in the herd?

69. Are any animals purchased for resale? How many? How long are those animals kept prior to resale?

Describe any feeding program utilized prior to sale?

70. Describe the type of animal being selected for purchase and subsequent resale (include weights at time

of purchase and weights at time of resale, as well as approximate ages at time of purchase and

subsequent resale).

71. Who makes the selection of these animals and why?

72. Who determines when the animals are ready to sell?

USE OF ANY EXPERTS OR ADVISORS:

73. Have you relied upon any experts or advisors?

74. Cite instances where you have chosen to implement your advisor’s recommendations?

75. How did the advisor’s recommendations impact the performance of the activity?

76. Describe any instances when you have chosen not to heed the advice of the expert and state why?