Determination of a profit motive.

Individual taxpayers often engage in more than one business venture. However, when a business also involves personal pleasure or recreation, the IRS may take notice. If the operation generates large losses that offset income from other sources, a taxpayer should consider all facts and circumstances before deciding to deduct the losses. IRC section 183, "Activities Not Engaged in For Profit," contains nine factors a taxpayer can use to determine whether an activity has a profit motive or is a hobby.

Harold and Julia Kahla were the sole shareholders of a profitable S corporation. They also owned two ranches in Texas. One had 300 head of cattle and the other was being developed for professionally guided deer hunts. Mr. Kahla grew up on a ranch and had extensive experience breeding and raising cattle. He also was an experienced deer hunter. He maintained a home at each ranch and spent approximately 40% of his time there--for both professional and personal purposes.

Accounting records for the ranches were combined with the Kahlas personal bank accounts and consisted only of canceled checks and invoices. Contract labor and employees of the couple's S corporation worked on the ranches. The Kahlas reported net losses of more than $1.8 million over a 21-year period on their schedule F. Only one year during that period showed net income--$3,873.

The IRS maintained that the Kahlas did not engage in ranching for a profit. It disallowed losses for 1992 to 1994, the period under examination, and assessed deficiencies of $204,423.

Result. For the IRS. The Tax Court examined all the facts and circumstances in relation to the nine factors in Treasury regulations section 1.183-2(b), as follows:

1. Manner of carrying on the activity. Poor recordkeeping was a major indicator the Kahlas lacked a profit motive.

2. Expertise of taxpayers or advisers. Mr. Kahla had cattle-ranching experience and sought advice from expert ranchers and others. Nevertheless, he did nothing to turn the ranches into profitable undertakings and did not "demonstrate an expertise for the economics of these operations."

3. Time and effort expended in the activity. While the taxpayer spent a good deal of time at the ranches, it was unclear whether it was for personal or professional activities.

4. Expectation that assets may appreciate. Both ranches appreciated in value over the years in question, but accumulated losses exceeded any actual or anticipated increase.

5. Past success in other activities. During the trial, Mr. Kahla said if his S-corporation were losing money, he would just "fix it." This attitude contrasted with the ranch losses and his failure to stop them.

6. History of income or losses from the activity. The taxpayer maintained the losses occurred due to start-up costs and unforeseen circumstances such as drought and price fluctuations in the cattle market. Mr. Kahla testified that he did not expect the operation to be profitable in the near future and yet he did not take corrective action.

7. The amount of occasional profits earned, if any. One year of profits in a 21-year period without any foreseeable change indicated to the Tax Court the Kahlas had undertaken the operation for purposes other than to earn income.

8. Taxpayer's financial status. For the three years under examination, taxable income from other sources ranged from $500,000 to more than $800,000. The ranch losses provided considerable tax savings.

9. Elements of personal pleasure or recreation. The taxpayers frequently used the homes on the ranches for personal entertainment.

The regulations specify that no one factor should be considered decisive; the 1990 case of Keanini v. Commissioner (94 TC) affirmed this. Given the facts and circumstances surrounding both of the Kahlas' ranches, the Tax Court concluded there was no profit motive and disallowed all losses for the three years under examination. Expenses related to the operations were allowed only to the extent of revenues generated from the "hobby," as mandated by section 183.

Business expenses are fully deductible only if a taxpayer incurs them in a profit-motivated activity. For an operation with frequent net losses, the IRS and the courts will closely examine the facts and circumstances in relation to the details set forth in the regulations. If the taxpayer derives apparent personal pleasure from an endeavor and has substantial income from other sources, taxpayer actions must support the intention to generate a profit; otherwise, the IRS will disallow the losses and expenses will be deductible only to the extent of revenue generated.

* Harold S. and Julia A. Kahla v. Commissioner, TC Memo 2000-127.

--Prepared by Cynthia Bolt Lee, CPA, assistant professor, Department of Business Administration, the Citadel, Charleston, South Carolina.