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Animals and Taxes

from The Arkansas Lawyer Spring 2022

from The Arkansas Lawyer Spring 2022, page 12

Animals and the Law

By Anthony A. (Tony) Hilliard

Anthony A. (Tony) Hilliard, JD CPA, former President of the Arkansas Bar Association, practices tax, estate planning, probate and corporate law with the Ramsay, Bridgforth, Robinson & Raley LLP law firm in Pine Bluff, Arkansas. He is pictured with his wife Mary and dog Annie. In 2020 my wife, Mary, and I decided to get a puppy. Mary, newly retired, grew bored cooped up by herself during the pandemic. I wanted a manly-man hunting dog. Mary wanted a Maltese. We compromised and got a Maltese. After learning the price, I strongly suggested we start breeding Maltese. Mary then asked the most important question every person must consider before entering into any new enterprise: “What do you know about breeding dogs?” I knew you needed a boy dog and girl dog, but not much else. Annie (because we got her on our Annie-versary) is now a happy, spoiled dog, fixed and costing us more money on vet bills and special diet food, with no chance of ever deducting those expenses on our taxes. Pets don’t qualify as a dependent.

The federal and Arkansas tax codes allow business deductions for activities entered into with the intent to make a profit.1 However, the codes limit hobby deductions to the gross income from the hobby.2 Hobby income includes all gains from the sale or other disposition of property and all other gross receipts derived from such activity reduced by the cost of goods sold.3

The IRS knows high income taxpayers will often report “business losses” for taxpayer activities not engaged in for profit.4

Several years ago Dr. Knudsen, an OB/GYN physician, and his wife decided to raise parrots. Dr. Knudsen spent his spare time working in their exotic animal breeding operation called El Rancho Exotica (“Exotica”). Mrs. Knudsen managed Exotica. Mrs. Knudsen completed 32 hours of business courses but did not hold a business degree. She had no formal training in animal care or zoo science. Dr. and Mrs. Knudsen believed a great market existed for parrots trained to eat from the owner’s hand. The Knudsens read several books, attended a seminar on hand raising parrots, and read “Bird Talk” magazine as well as met with its editor on raising parrots. Otherwise, the Knudsens had no experience in raising parrots for profit. Further, they had no business plan or economic projections to show they could make a profit in the business. Eventually they expanded Exotica to include different types of birds, camels, llamas and other exotic animals on a farm they bought to support Exotica. As you would expect, between 1995 and 2002 the Knudsens wrote off over $2,860,000 in tax losses from Exotica.5

The Knudsens noted that they also expected the appreciation in value of the animal assets as the herd or flock grew in number would generate profits for them. The Tax Court agreed that “profit” for this purpose includes appreciation of the assets over several years but noted the huge expenses the Knudsens incurred in feed and other expenses made it highly unlikely they would ever make a profit with Exotica.6

After reviewing the relevant factors the Tax Court concluded that the Knudsens had no specific knowledge related to the breeding of animals, had not consulted with experts, had not taken the time to learn how to make the business profitable and had

"... the best advice any lawyer can give to a client preparing to enter a new enterprise but worried about the hobby-loss rule is approach the enterprise in a business-like manner."

failed to prove they were making a concerted effort to make the business profitable. The IRS maintained, and the Court agreed, that the Knudsens’ animal breeding was a hobby which meant the Knudsens could not deduct Exotica’s losses.7

The Code presumes that if gross income from the activity exceeds deductions for three of the past five consecutive tax years, then unless the IRS determines otherwise, the activity is engaged in for profit.8 The Code is more generous with horse breeding, training, showing or racing and allows the presumption that the taxpayer engaged in the horse enterprise for profit if gross revenues from the enterprise exceeded tax deductions from the enterprise for two of the seven consecutive years, including the tax year in question.9 However, many other factors also help determine the hobby status of an enterprise.

A recent cattle ranching case gives excellent insight into the factors used to determine whether a taxpayer may deduct losses from an enterprise. Paul Wicks owned Wicks and Associates, a highly profitable oil and gas inspection company. His income averaged almost $1,000,000 a year and he employed up to 80 employees during this time.10 The Court also found it important that the company had a separate checking account and one employee had an accounting degree, used Quickbooks accounting software and handled accounting duties.11 Wicks bought a cattle ranch in 1997. As of the tax year ending December 31, 2015, Wicks had not made a profit in a single year for the prior 18 tax years and had lost over $807,000 in those 18 years.12

To determine if Wicks’ cattle ranch was a hobby and ineligible to deduct the losses, the Court looked to nine factors set out by Treasury Regulation Section 1.183-2(b). 1. Business like manner.13 Wicks had not prepared a business plan or financial projections, used QuickBooks or any other accounting software, created a separate bank account for the enterprise, executed any written contracts, formed a business entity, marketed or promoted his cattle operations, insured his cattle against catastrophic loss, consulted a financial adviser or even tracked anything related to profits and losses of his cattle operation.14 The Court noted that Wicks “employed a variety of sophisticated financial practices in running Wicks and Associates.”15 The court found that while his operations are similar to other ranchers, his “rudimentary” records and failure to use sophisticated business practices favors the IRS determination that the cattle ranch was not operated in a business like manner.16 2. Expertise of the Taxpayer or his Advisers.17 The Court found the evidence showed Wicks engaged in “self-education” by attending seminars but didn’t seek “any formal cattle ranching education or hire paid consultants or experts.”As such, the Court determined this factor was neutral.18 3. Time and Effort Expended in Carrying on the Activity where the activity does not have substantial personal or recreational aspects.19 The IRS argued that because Wicks had a full-time occupation, this factor favored determining the cattle ranch was a hobby. However, the Court noted Wicks worked three to four days a week at the ranch “which entails hard physical labor, and [the IRS] points to no evidence demonstrating that this physical labor has substantial personal or recreational aspects for [Wicks].” Therefore, the Court found this factor favors Wicks trying to make a profit.20 4. Expectation that Assets used in Activity may Appreciate in Value.21 The Court ignored the cattle breeding since the calves went into inventory, not capital, and his equipment was depreciating. However, the Court determined Wicks purchased and improved most of his land for the cattle business with the reasonable expectation of the “appreciation of … the value of the capital improvements made on the land,” which factor favors Wicks.22 5. The Success of the Taxpayer in Carrying on Other Activities.23 The Court noted Wicks was very successful with Wicks and Associates, but was not employing any of the business skills that made Wicks and Associates successful except the same work ethic he uses at Wicks and Associates. The Court determined this factor was neutral.24 6. Taxpayer’s History of Income or Losses with Respect to the Activity.25 The Court found that Wicks’ failure to make any profit over the course of 18 years indicated the lack of a profit motive but also acknowledged that for the tax years in question, Wicks had demonstrated a drought and depressed cattle market beyond his control contributed to his losses, which must also be considered.26 7. The Amount of Occassional Profits Earned.27 While the Court found this factor favored the IRS because Wicks had never earned a profit on his cattle operations, it also acknowledged “that small farming operations are not, generally speaking, lucrative

businesses.”28 8. The Financial Status of the Taxpayer.29 The regulation provides that substantial income from other sources “may indicate the activity at issue is not engaged in for profit, especially where losses from the activity generate substantial tax benefits and there are personal or recreational elements involved.”30 However, the Court found no evidence of a personal or recreational element to the cattle ranching. The Court found this factor indicates the cattle ranch is for profit.31 9. Elements of Personal Pleasure or Recreation.32 The IRS conceded raising cattle generally lacks significant recreational aspects and presented no evidence that Wicks engaged in cattle ranching for personal or recreational purposes.33

After examining all the factors, the Court determined that Wicks was engaging in the cattle ranching for profit and the IRS should refund the taxes it collected prior to the case when it disallowed the losses.34

Bearing the above elements in mind, the best advice any lawyer can give to a client preparing to enter a new enterprise but worried about the hobby-loss rule is approach the enterprise in a business-like manner. Develop a budget and project if the enterprise will be profitable. Keep detailed and accurate records with corresponding receipts. Either bring relevant experience to the enterprise or hire an expert to advise how to make the enterprise profitable. Adapt and adjust if the enterprise fails to make a profit. Finally, try to make a profit at least three out of every five years if at all possible.

Endnotes:

1. I.R.C. § 162 and Ark. Code Ann. § 2651-423. 2. I.R.C. § 183 and Ark. Code Ann. § 2651-424(c). 3. Treas. Reg. § 1.183-1(e). 4. See IRS IRC §183 Audit Guide Rev. 6/09. 5. See Knudsen v. C.I.R., T.C. Memo 2007340. 6. Id. 7. Id. 8. I.R.C. §183(d). 9. Id. 10. Wicks v. United States, 304 F. Supp. 3d 1079, 1086 (N.D. Okla. 2018). 11. Id. 12. Id. 13. Treas. Reg. § 1.183-2(b)(1). 14. Wicks, 304 F. Supp. 3d at 1095. 15. Id. at 1096. 16. Id. 17. Treas. Reg. § 1.183-2(b)(2). 18. Wicks, 304 F. Supp. 3d at 1095. 19. Treas. Reg. § 1.183-2(b)(3). 20. Wicks, 304 F. Supp. 3d at 1098. 21. Treas. Reg. § 1.183-2(b)(4). 22. Wicks, 304 F. Supp. 3d at 1098. 23. Treas. Reg. § 1.183-2(b)(5). 24. Wicks, 304 F. Supp. 3d at 1098. 25. Treas. Reg. § 1.183-2(b)(6). 26. Wicks, 304 F. Supp. 3d at 1099. 27. Treas. Reg. § 1.183-2(b)(7). 28. Wicks, 304 F. Supp. 3d at 1099. 29. Treas. Reg. § 1-183-2(b)(8). 30. Wicks, 304 F. Supp. 3d at 1099. 31. Id. At 1100. 32. Treas. Reg. § 1-183-2(b)(9). 33. Wicks, 304 F. Supp. 3d at 1100. 34. Id. ■