Academic journal article Journal of Accountancy

Determination of a Profit Motive

Academic journal article Journal of Accountancy

Determination of a Profit Motive

Article excerpt

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. …

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