Tax Court allows cattle ranch deductions

The Tax Court ruled in favor of a Texas cattle rancher, rejecting the IRS’s denial of deductions of some expenses of his farming and ranching activities. Despite significant operating losses and his receipt of substantial passive income from oil and gas royalties on the same property, the court held that the taxpayer could deduct the losses associated with the farming and ranching activity.

Facts: Kenward F. Kolar Jr. inherited the Kolar ranch, which comprises roughly 836 acres in south central Texas. Over several generations, his family had operated agricultural enterprises there, including dairy and beef cattle operations, poultry and egg production, catfish raising, hay cultivation, and pecan orchards, alongside various nonagricultural pursuits. In more recent years, mineral rights transactions emerged as a significant income source.

Kolar spent most of his life on or near the ranch property. He obtained a bachelor’s degree in animal science and biology and a master’s degree in water supply and wastewater disposal. Following his studies, he rejoined his father on the ranch as a worker.

Kolar’s father died in 2010, and Kolar inherited the ranch land, while his mother inherited the financial assets associated with the ranch and took over its operations. However, she soon fell ill, and in 2016, Kolar assumed management of the ranch until her death in 2017. Kolar then took full ownership of the ranch’s various enterprises and financial assets.

Years of inadequate oversight during his father’s extended illness and his mother’s declining health had left the ranch in a deteriorated condition. The restoration challenge was substantial: Fencing systems required rebuilding, antiquated equipment needed replacement, pastureland required clearing of overgrowth, and the beef cattle herd needed to be rebuilt. In addition, significant portions of the ranch had become invaded by huisache, a small, thorny tree with bush-like characteristics that rendered large areas unsuitable for cattle ranching or other productive uses.

Even after restoring the ranch infrastructure, Kolar’s projections indicated a five- to six-year timeline to restore profitability to the cattle operation. The ranch demanded his full attention, requiring him to work long daily hours throughout the week. Kolar envisioned growing the herd to approximately 250 animals, a size that could generate several hundred thousand dollars in value at prevailing market rates, and he contemplated further expansion if his son eventually succeeded him in operating the ranch. His emotional connection to the family property was strong, and he hoped to establish a multigenerational succession plan.

Throughout this period, his wife handled the ranch’s financial recordkeeping, maintaining documentation that the couple provided to their CPA. Ranch operations used a dedicated bank account kept separate from the family’s personal household finances. The court observed that the financial management demonstrated professional standards, noting that Kolar operated the ranch “in a businesslike manner.” Kolar’s wife employed a comprehensive, multistage recordkeeping system that included maintaining a check register and a “category” book for daily transaction recording. She compiled a “weekly book” for regular financial reviews with her husband, then created monthly Microsoft Excel spreadsheets and consolidated year-end spreadsheets capturing all ranch revenues and expenditures.

Agricultural operations represented only part of the ranch’s revenue. Royalties from oil and gas extraction from the ranch provided substantial nonagricultural income. Between 2017 and 2022, Kolar’s reported royalty income totaled $2,349,780.

Water sales from the ranch’s artesian wells provided another revenue stream. The ranch retained some well water for the cattle herd and pasture irrigation but sold the remainder. During 2016 and 2017, Kolar generated income by selling well water to oil companies operating on the ranch and to nearby pecan growers. These water sales produced revenues ranging from $500 to $40,000 during the period.

The ranch endured several catastrophic events during this period. Hurricane Harvey struck in 2017, destroying a substantial portion of the ranch’s financial records. The 2020 COVID-19 pandemic claimed the lives of three of the ranch’s five employees. In February 2021, a winter storm left the ranch without electricity for 2½ weeks. The extreme cold caused the well infrastructure to freeze and rupture, cutting off the cattle’s primary water supply, which resulted in numerous cattle perishing from dehydration. Fire, drought, grasshopper infestations, and flooding added to the operational challenges during this time.

Despite these disruptions, Kolar continued to raise and sell cattle on a limited scale. Between 2016 and 2020, cattle prices fluctuated significantly, based on market dynamics and animal quality, with per-pound prices varying from a bottom of $0.34 to a peak of $1.50, with cattle typically weighing between 750 and 1,600 pounds. Fifteen head of cattle were sold in 2021.

The IRS assessed Kolar a $292,247 deficiency for 2016, along with penalties under Secs. 6651(a)(1), 6651(a)(2), and 6654. Kolar accepted the IRS’s unreported income determination of $828,925, and the parties agreed to $146,191 in offsetting expense deductions. He also accepted responsibility for the penalty assessments.

Issues: After Kolar’s concessions, the question at issue was whether Sec. 183’s restrictions on activities lacking a profit motive barred the deduction of an additional $205,514 in farm-related expenses that Kolar claimed for 2016.

Taxpayers are allowed deductions for ordinary business expenses as well as costs incurred in producing or collecting income under Secs. 162 and 212, respectively. Sec. 183 limits these deductions in the case of an individual or S corporation that engages in an activity without a profit motive, with exceptions (1) for deductions that would be allowed without regard to whether the activity was engaged in for profit or (2) to the extent that gross income from the activity exceeds otherwise allowable deductions (Sec. 183(b)). Deductions are not allowable under Sec. 162 or 212 for activities that are carried on primarily as a sport, hobby, or for recreation (Regs. Sec. 1.183-2(a)).

Before profit motive is evaluated, the relevant activity must be identified (Regs. Sec. 1.183-1(d)(1)). When taxpayers pursue multiple ventures, each might constitute a distinct activity, or several ventures might be consolidated into one activity if adequately interrelated (Welch, T.C. Memo. 2017-229). The IRS typically defers to how taxpayers characterize their ventures — whether as unified or separate activities. Yet the IRS will not accept a taxpayer’s characterization if it appears artificial or is not supported by the facts and circumstances (Regs. Sec. 1.183-1(d)(1)).

The IRS contended that cattle ranching alone constituted the relevant activity. Kolar asserted that the ranching activity’s scope encompassed not only cattle operations but also land appreciation and related ventures, including oil and gas resource development, reasoning that infrastructure improvements such as roads and fencing served both livestock and mineral extraction purposes. Under the Sec. 183 framework, land appreciation can be aggregated with ranching only when the ranching operations are independently profitable (excluding property holding costs), such that the ranching justifies maintaining the land for appreciation (Regs. Sec. 1.183-1(d)(1); Young, T.C. Memo. 2025-95).

The fundamental question in determining whether the additional expenses claimed by Kolar were deductible was whether his 2016 ranching activities constituted a profit-motivated activity. Profit motive exists when the taxpayer holds a genuine and honest profit objective at the relevant time (Regs. Sec. 1.183-2(a)). This standard requires a bona fide profit objective (Dreicer, 78 T.C. 642, 644–45 (1982), aff’d, 702 F.2d 1205 (D.C. Cir. 1983) (unpublished table decision)). Courts assess profit motive by examining all the surrounding facts and circumstances (Regs. Secs. 1.183-2(a) and (b)). Objective evidence carries more weight than taxpayer declarations of intent (Regs. Sec. 1.183-2(a)).

Regs. Sec. 1.183-2(b) sets out nine nonexclusive factors to be used in determining whether an activity is undertaken with a profit motive: (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 similar activities; (6) the taxpayer’s history of income or loss with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved. The regulations state that no one factor is determinative, and a court should not make its determination based solely on the number of factors “indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa” (Regs. Sec. 1.183-2(b)).

Courts may consider evidence from years beyond the tax year in question when such evidence illuminates profit motive, although the central focus remains on the year(s) at issue and any future prospects as they appeared at that time (Himmel, T.C. Memo. 2025-35; Smith, T.C. Memo. 1993-140).

Holding: The Tax Court held that the ranching activity generally, not including land appreciation and oil and gas exploitation, was the activity to which the Sec. 183 test was appropriately applied because the ranching activity was not independently profitable. The court, however, agreed with Kolar that the ranching activity extended beyond just cattle ranching and included the development of the well water that, while generating some separate revenue, was used to provide water to the cattle herd.

After applying the nine factors set out in Regs. Sec. 1.183-2(b) for determining whether an activity is engaged in for profit, the Tax Court held that the Sec. 183 limitations did not apply for 2016 and Kolar could deduct the $205,514 in additional farm expenses he claimed for that year. Of the nine factors, the court found that four favored Kolar (manner of operation, expertise, time and effort, and lack of personal pleasure), two were neutral (asset appreciation and success in similar activities), and three weighed against a profit motive (history of losses and amount of occasional profits (both weighing only “slightly” against) and financial status).

The Tax Court noted, though, as it had discussed earlier in its opinion, in determining profit motive, “reaching a decision involves more than simply tallying the factors for and against; a qualitative analysis is required.” With respect to the sixth factor (history of losses), the court found that the size of Kolar’s reported losses relative to gross receipts was “troublingly large,” i.e., more than $2 million in losses, approximately 77.3 times greater than the $25,874 in gross receipts from farming and ranching reported for 2017–2022. However, the court accepted Kolar’s explanation that the losses were characteristic of the startup phase required to restore the ranch and were increased by unforeseeable setbacks such as Hurricane Harvey, the COVID-19 pandemic, and the severe winter storm in 2021.

In the Tax Court’s view, the largest factor weighing against a profit motive was that Kolar had substantial oil and gas royalty income that could offset ranching losses. However, the court found that this factor “simply does not outweigh the other factors in favor of a profit motive.”

• Kolar, T.C. Memo. 2026-15

— Thomas Godwin, CPA, CGMA, Ph.D., and John McKinley, CPA, CGMA, J.D., LL.M., are both professors of the practice in accounting and taxation in the SC Johnson College of Business, and Chelsea Xian is an MPS student in management, specializing in accounting, in the Johnson Graduate School of Management, all at Cornell University in Ithaca, N.Y. To comment on this column, email Paul Bonner, the JofA‘s tax editor, at Paul.Bonner@aicpa-cima.com.