Tax Court in Brief | Wondries v. Comm’r | Deficiencies for Deduction of Farm and Ranch Expenses; Hobby or Activity Engaged in For Profit?

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The Tax Court in Brief – January 9th – January 13th, 2023

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Tax Litigation:  The Week of January 9th, 2022, through January 13th, 2023

Wondries v. Comm’r, T.C. Memo. 2023-5| January 9, 2023 | Kerrigan, J. | Dkt. No. 13345-19 (deficiencies for deduction of farm and ranch expenses; evaluation of activity not engaged in for profit).

Summary: Paul Wondries and Patricia Wondries (the Wondries) sought relief from the Tax Court to review the IRS’s determinations of deficiencies and accuracy-related penalties arising mainly from deductions for expenses reported on Schedules F, Profit or Loss from Farming, for tax years 2015, 2016, and 2017 and for an underpayment related to an IRA distribution. The Wondries owned a ranch, and they hired a foreman to manage the ranch. They quickly decided that the property would not produce sufficient income as a ranch or for guided hunts, so the Wondries began to improve the property for potential sale. Mr. Wondries performed the accounting and payroll function for the ranch. He maintained a running total of expenses incurred throughout the year as well as copies of checks and receipts. He also engaged an accountant to periodically review the ranch accounting work. Since acquiring the ranch, the Wondries never realized a profit nor broken even. They realized a net loss every year since the purchase in 2004 and have claimed corresponding deductions. For each of the years in issue the Wondries reported no more than $12,500 in income and expenses ranging from $235,580 to $474,793, which resulted in substantial losses. The IRS examined the Wondries’ returns and determined that the ranch property was an activity not engaged in for profit and thus determined deficiencies relating to the Wondries’ deductions of the ranch expenses.

Key Issues: (1) Whether the Wondries are entitled to deductions for expenses reported on the Schedules F, Profit or Loss From Farming, attached to their 2015, 2016, and 2017 federal income tax returns? (2) Whether the Wondries are liable for accuracy-related penalties pursuant to section 6662(a) for 2015 and 2016?

Primary Holdings: (1) Yes. After weighing all the facts and circumstances, and by applying the non-exhaustive factors contained in the Treasury Regulations, the Tax Court concluded that the Wondries engaged in their ranching activity for profit and not as a hobby. The Court did not sustain the IRS’s disallowance of the loss deductions related to the ranching activity under section 183. (2) Yes. The Wondries are liable for an accuracy-related penalty as it pertains to an underpayment related to an IRA distribution but not for the penalties determined for the expense deductions for the ranch activity.

Key Points of Law:

Burden of Proof. The determinations in a notice of deficiency bear a presumption of correctness, and the taxpayer generally bears the burden of proving them erroneous in proceedings in this Court. See Welch v. Helvering, 290 U.S. 111, 115 (1933); Rule 142(a)(1).

For-Profit Business. Taxpayers are generally allowed deductions for business-related and investment expenses. See 26 U.S.C. §§ 162, 212. Under section 183(a), individuals are not allowed a deduction “if such activity is not engaged in for profit.” “[I]f such activity is not engaged in for profit, no deduction attributable to such activity [is] allowed” except to the extent provided by section 183(b). Id. at § 183(a). Section 183(b) allows deductions that would have been allowable had the activity been engaged in for profit but only to the extent of gross income derived from the activity (reduced by deductions attributable to the activity that are allowable without regard to whether the activity was engaged in for profit). 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 section 162 or under paragraph (1) or (2) of section 212.”

Primary Objective of Making a Profit. For expenses to be fully deductible under section 162 or 212, taxpayers must show that they are engaged in the activity with the primary objective of making a profit. Westbrook v. Commissioner, 68 F.3d 868, 875 (5th Cir. 1995), aff’g T.C. Memo. 1993-634; Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993), aff’g T.C. Memo. 1991-212. “The term profit encompasses appreciation in the value of assets, such as land, used in the activity. Thus, the taxpayer may intend to derive a profit from the operation of the activity, and may also intend that, even if no profit from current operations is derived, an overall profit will result when appreciation in the value of land used in the activity is realized since income from the activity together with the appreciation of land will exceed expenses of operation.” Treas. Reg. § 1.183-2(b)(4).

The expectation of a profit need not be reasonable, but the taxpayer must conduct the activity with the actual and honest objective of making a profit. Keating v. Commissioner, 544 F.3d 900, 904 (8th Cir. 2008), aff’g T.C. Memo. 2007-309. Greater weight is given to objective facts than to the taxpayer’s self-serving statement of intent. King v. Commissioner, 116 T.C. 198, 205 (2001); Treas. Reg. § 1.183-2(a) and (b).  A profit objective may be inferred from expected appreciation of the activity’s assets only where the appreciation exceeds operating expenses and is sufficient to recoup accumulated losses of prior years. See Golanty v. Commissioner, 72 T.C. 411, 427–28 (1979), aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981).

Factors. The regulations provide a non-exhaustive list of nine factors that should be considered: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or the taxpayer’s advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar activities; (6) the taxpayer’s history of income or loss with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved. Treas. Reg. § 1.183-2(b). “No one factor is determinative,” and it is not intended that “a determination is to be made on the basis that the number of factors . . . indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa.” Id.

Accuracy-Related Penalties. The IRS bears the burden of production with respect to the liability of an individual for any penalty. See 26 U.S.C. § 7491(c). The IRS satisfies that burden by presenting sufficient evidence to show that it is appropriate to impose the penalty in the absence of available defenses. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). This includes satisfying section 6751(b)(1), which provides that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” The written supervisory approval is not required to take any specific form, but it generally must be obtained no later than (1) the date on which the IRS issues the deficiency notice, or (2) the date, if earlier, on which the IRS formally communicates to the taxpayer the Examination Division’s determination to assert a penalty. See Belair Woods, LLC v. Commissioner, 154 T.C. 1, 15 (2020); Palmolive Bldg. Invs., LLC v. Commissioner, 152 T.C. 75, 85–86 (2019). Section 6662(a) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax required to be shown on a return if, as provided by section 6662(b)(1), the underpayment is attributable to “[n]egligence or disregard of rules or regulations.” Negligence includes “any failure to make a reasonable attempt to comply” with the internal revenue laws, and “disregard” includes “any careless, reckless, or intentional disregard.” 26 U.S.C. § 6662(c). Negligence also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly. Treas. Reg. § 1.6662-3(b)(1).

Insights: This Wondries opinion is a great example of the analysis the Tax Court uses for determining whether a taxpayer is allowed a deduction for a business activity that, by the numbers, does not come close to making a profit. Under section 183(a) of the Code, individuals are not allowed a deduction “if such activity is not engaged in for profit.” The motives behind a particular endeavor are important, and the Treasury Regulations provide at least nine factors that the Tax Court (and taxpayers) should apply in arriving at a business decision on expense deductions relating to an unprofitable business endeavor. As the Tax Court in Wondries noted, “This is a close case.” And, the scale of factors tipped in the favor of the Wondries.