Starting any business has risk, and most businesses take time to become profitable. Unfortunately, the IRS sees multiple years of losses from a business as a red-flag that usually results in further scrutiny. That scrutiny can result in disallowance of legitimate business losses and potential penalties for the underreporting. However, with the proper documentation and testimony, legitimate losses over multiple years can be taken and upheld. A recent Tax Court case on a miniature donkey businesses, Huff v. Comm’r, T.C. Memo 2021-140, outlines the factors needed to defend multiple years of losses in a business.
Huff v. Comm’r
The taxpayers in Huff were a wealthy couple that made their previous fortune with an investment business. Their daughter was an animal lover who owned and operated a dog grooming business her parents had helped her finance and maintain operations. That dog grooming business, however, only produced limited income for their daughter. The Huffs decided that starting a miniature donkey business they could turn over to their daughter, once profitable, could offer a good supplemental income. Mr. Huff used his business and investment knowledge and the help of an expert in miniature donkey breeding, marketing, and sales to start and operate the business (Ecotone). However, despite best efforts, the business sustained losses for tax years 2010 through the time of trial. The Huffs claimed losses on their personal income tax returns and the IRS disallowed the losses and assessed penalties for the underreporting. The Huffs then challenged that disallowance in Tax Court and won.
Determination of Profit Motive
Taxpayers generally can deduct all ordinary and necessary business expenses paid or incurred in carrying on a trade or business. See IRC §162. However, if the activity is determined to lack a profit motive or is carried on primarily as a sport, hobby, or recreation then the deductions are not allowed. See IRC §183. This determination of profit motive includes a dominant hope and intent of realizing a profit even if the expectation is not necessarily reasonable so long as a taxpayer entered into and continued the activity with profit as the objective. See Cornfeld v. Comm’r, 797 F.2d 1049, 1053 (D.C. Cir. 1986), aff’g T.C. Memo 1984-105; Brannen v. Commissioner, 722 F.2d 694, 704 (11th Cir. 1984, aff’g 78 T.C. 471 (1982); Hulter v. Comm’r, 91 T.C. 371, 393 (1988). The breeding of horses is frequently challenged and losses associated with claimed businesses are disallowed when determined that the activity is more hobby than business entered into for profit. See e.g. Helmick v. Comm’r, T.C. Memo 2009-220. The determination, however, must be made through analysis of all the facts and circumstances because a potential hobby can be a legitimate business if certain factors are met. Even though intent is important, greater weight is given to objective facts. IRS regulations provide nine objective factors to consider when determining a true profit motive. These factors are 1) the manner in which the taxpayer carries on the activity; 2) the expertise of the taxpayer or his advisors; 3) the time and effort expended by the taxpayer 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 or dissimilar activities; 6) the taxpayer’s history of income or losses with respect to the activity; 7) the amount of occasional profits, if any, from the activity; 8) the financial status of the taxpayer; and 9) elements of personal pleasure or recreation. See Treas. Reg. 1.183-2(b).
Although documentation is key in resolving many disputes with the IRS, the Tax Court noted that Mr. Huff’s testimony at trial was particularly helpful evidence of the hope and intent of making a profit. Therefore, even though Ecotone’s business operation was not profitable up to the time of trial, the court did not believe it lacked a profit objective in the years at issue. The Tax Court noted that the approach “might have been misguided” and “might never turn a profit” but also that “incorrect business judgment does not belie an honest profit motive.” The Tax Court considered all nine factors in making its determination that profit motive existed and the losses claimed were legitimate. There was a clear business plan, which weighed in favor of the taxpayers, but the recordkeeping raised questions because the books were properly kept but “little attention” was given to the expenses incurred. Although the IRS challenged certain decisions made during operations, the Tax Court found that attempts to adapt operations showed an attempt to fix non-profitability. The Tax Court also points to the consultation and time and effort of both the taxpayers and their expert advisors and the previous business experience of Mr. Huff in concluding there was profit motive.
What about the decade of losses? The Tax Court noted that the regulations themselves indicate that losses during the initial or startup stage does not indicate a lack of profit motive and that certain businesses may take years to finally generate a profit. Ultimately, the Tax Court found that the business was still in the startup phase so the continued losses did not negate a legitimate profit motive.
What about the wealth of the Huffs? The IRS made several attacks against the reasons given for profit motive by pointing to the extreme wealth of the taxpayers (i.e. approximately $21 million each year). The miniature donkey business was a relatively small venture, so the IRS claimed that it was not for profit but to generate agricultural exemptions, a deductible way to remodel their farmland, or a false business to divert revenue to their daughter. The Tax Court rejected all these claims and this is where Mr. Huff’s testimony proved the most useful. The Tax Court found his testimony credible in explaining his refusal to give his daughter a business that was losing money, plans to shutter the business if it never proved profitable, and that there were far easier ways to give his daughter money than this business venture. Ultimately the court found, “based primarily on Mr. Huff’s testimony”, that the Huffs believed that the operations would eventually turn a profit and they had the requisite primary purpose and intent to make a profit to allow the loss deductions and deny the proposed penalties.
Testimony v. Documentation
The Huff case shows the importance of testimony in certain tax disputes. When documentation isn’t available, or doesn’t explain all the relevant and important facts, the taxpayer must tell their story. Preparing the testimony is sometimes a difficult task because it can, if not done properly, come off as entirely self-serving. Presenting that testimony in an organized, efficient, and convincing way can be the difference in winning or losing the arguments – it apparently made the difference in this case.
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