Alan Miller became a successful entrepreneur while living in Van Meter, Iowa, about 20 miles west of Des Moines After making a success out of Electric Pump and Tool Services, he developed an interest in Paso Fino horses – an interest that led him to move to Florida and engage a prominent trainer to help him develop his herd.
Horses cost money, and Mr. Miller’s schedule C’s reflected that, according to a Tax Court opinion issued yesterday:

Beginning in 2002 and continuing in 2003, 2004, 2005, and 2006 Mr. Miller filed a Schedule C, Profit or Loss From Business, listing his principal business as “show horse breeding”. In 2002 Mr. Miller reported losses of $95,571 on his Schedule C. In 2003 Mr. Miller reported losses of $126,377 on his Schedule C and losses of $9,223 on Form 4797, Sales of Business Property. In 2003 Mr. Miller sold three horses at a loss. In 2004 Mr. Miller reported Schedule C losses of $139,098 and losses of $13,742 on Form 4797. In 2004 Mr. Miller sold one horse at a loss

The IRS invoked the Section 183 “hobby loss” rules, saying that Mr. Miller wasn’t really trying to make money. The court ruled for Mr. Miller and against the IRS. Mr. Miller had some important facts on his side:
- He kept good financial records
- He kept his business and personal horses separate, and did not deduct expenses for his personal mount.
- He kept logs of his business activity, recording 800-1000 hours per year on the horse breeding.
- He modified his business to fix bad results.
- He engaged experts to improve his busineses.
- He had a track record of success as an entrepreneur.
- He had a plausible plan to show a profit.
The more typical hobby loss facts feature a professional – a doctor, lawyer, dentist or accountant – who spends full time on his professional activity, keeps poor records, and has no hope of ever making money.
Congratulations to local attorney Ron Mountsier, who lawyered the winning case.
Cite: Miller, T.C. Memo 2008-224.
Related: Hobby losses dog IRS auditor

The IRS has issued a new “fact sheet” (FS-2008-23) on the so-called “hobby loss” rules of Code Section 183. The tax law itself doesn’t use the term “hobby loss”; it revers to “activities not engaged in for profit.” Even if you aren’t having any fun at all, the IRS will disallow loss deductions if they think you aren’t serious about trying to show a profit.
The fact sheet lists the following factors the tax law uses to determine whether there is a profit objective:

* Does the time and effort put into the activity indicate an intention to make a profit?
* Do you depend on income from the activity?
* If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
* Have you changed methods of operation to improve profitability?
* Do you have the knowledge needed to carry on the activity as a successful business?
* Have you made a profit in similar activities in the past?
* Does the activity make a profit in some years?
* Do you expect to make a profit in the future from the appreciation of assets used in the activity?

The classic “bad facts” under the hobby loss rule would be someone with a full-time job – say, a dentist – who offsets a high level of salary income with losses from a farm – maybe a horse farm – that never comes close to showing a profit. Multi-level marketers also frequently have trouble with the hobby loss rules.
If you are really trying to make a living from your business, Section 183 isn’t a problem. If you’re just playing at it because you like the tax deduction, you have a problem.

Kansas is a prosperous agricultural state, but you can’t try to raise just anything. Just ask Dennis and Margaret Knudsen.
These Liberal residents (Liberals? Libertarians?) took a fling at raising exotic animals. It’s not for the faint of heart, as the Tax Court explains:

* Petitioners lost many bird eggs and chicks after an employee brought her young child into the bird breeding facility.
* Wind storms caused eye problems for the Rocky Mountain goats, which affected their breeding.
* A drought in Kansas negatively affected the breeding of many animals.
* A very expensive bird escaped after an employee left the bird cage open.
* A heater failed on a very cold night, resulting in the deaths of two bongos.
* Two Clydesdale horses died in a barn fire.
* Several gemsbok crashed into a fence during the barn fire, and one of them was killed.
* Several others lost market value after breaking their horns.
* A coyote killed a Black Buck antelope.
* A mountain lion killed an East African crowned crane and its chick.
* A male addax died during a windstorm.
* A giraffe died after slipping on wet ground.
* A giraffe calf died as a result of the cold weather on the night of its birth.

From 1995 through 2002, the Knudsens deducted over $2.9 million in taxable losses from the farm — not surpising, considering their Job-like litany of mishaps. Fortunately, Mr. Knudsen has a good day job as aon OB-Gyn physician. Unfortunately, the IRS came calling.
The tax law’s “hobby loss” rules (Section 183) disallow business losses from businesses “not engaged for profit.” Such losses carry forward against the day, if ever, that the business makes money. The Tax Court evaluated whether the Knudsen’s farming operation was a profit-seeking venture using nine tests in the section 183 regulations. The court decided that the farm passed one of the tests, failed six, and tied two. The Knudsens lost.
The Moral: If you want to farm the government, forget the giraffes and alpacas; best stick with the time-tested corn subsidy and CRP programs.
Taxable Talk has more.
Cite: Knudsen, T.C. Memo. 2007-340