The Tax Court held that a taxpayer with a cattle and tree farm but no cattle or previous or imminent tree harvest could not use the farm's losses to offset other income. According to the court, the farming activity did not qualify as being conducted for profit.
Facts: Sheepdog Farms LLC was formed by Stephen Whatley, a successful banker, in 2004. According to Sheepdog Farms' return, its principal activity was "farm," with a principal product or service listed as "cattle." In addition, the farming operations included maintenance of the property's timber, which was not expected to be harvested until after 2021, with an expected future value, according to an expert's testimony, of $332,000.
However, the farm did not have any cattle on the property until 2008, after Whatley was notified by the IRS that Sheepdog Farms was under audit. Similarly, although Whatley had consulted a forester when he bought the property in 2003, he did not establish a forest-management plan until after the IRS notified him of the audit.
During the years under audit (2004—2008), Sheepdog Farms reported $512,222 in net losses. Whatley spent about 700 hours a year on the farm but had no formal business plan. The IRS determined to adjust Whatley's returns to disallow the loss deductions from Sheepdog Farms under the Sec. 183 hobby loss rules. Whatley petitioned the Tax Court.
Issues: Sec. 162(a) allows a deduction of all ordinary and necessary expenses paid or incurred during the tax year of carrying on a trade or business. However, Sec. 183(b)(2) limits deductions to the amount of gross income derived from the activity if the activity was not engaged in for profit.
As evidence that he possessed expertise in farming, Whatley cited his family's experience in running a large farm in which he participated at an early age and that at age 27 he began a timber-harvesting operation. The CPA who advised Whatley on forming the limited liability company and prepared its tax returns testified that Sheepdog Farms was a business with a profit motive.
Holding: The court examined Sheepdog Farms under factors outlined in Regs. Sec. 1.183-2(b) and case law to determine if Whatley engaged in a farm business with the objective of making a profit. The regulation's factors are:
- The manner in which the taxpayer carries on the activity;
- The taxpayer's own expertise or that of his or her advisers;
- The amount of time and effort the taxpayer spends on the activity;
- Any expectation that assets used in the activity may appreciate in value;
- The taxpayer's success in carrying on similar (or dissimilar) activities;
- The taxpayer's history of income or loss with respect to the activity;
- The amount of any occasional profits from the activity;
- The taxpayer's financial status; and
- Any personal pleasure or recreation the taxpayer derives from the activity.
The court found eight of these nine factors to weigh against Whatley's claim. With respect to the second factor, the taxpayer's expertise, the court noted that despite his family background on a farm, Whatley had never operated a cattle farm. His previous timber experience had been over 35 years earlier and did not include growing trees.
One factor, Whatley's success in other activities, was classified as neutral. How Sheepdog Farms' operation compared with industry standards, a subfactor of the manner in which Whatley carried on the activity, the court also "generously" called neutral but on the whole considered this factor negative. The court also found the activity was not engaged in for profit from a "holistic" consideration. No factors favorably supported Whatley's claim that Sheepdog Farms was engaged in for-profit activities. The court stated, "A cattle farm without cattle and a tree farm that doesn't yet harvest timber is highly likely to produce a bumper crop of losses." Thus, the court found Sheepdog Farms was not a trade or business and disallowed the losses under Sec. 183.
- Whatley, T.C. Memo. 2021-11
— By Janet R. Jones, CPA (inactive), Ph.D., assistant professor of accounting, Stephen F. Austin State University, Nacogdoches, Texas.