Hobby Horse or Workhorse? When Ranch Losses Are Legitimate Business Deductions

Fighting to keep the ranch in the family has proven to make for dramatic television on shows such as Yellowstone. While not as cinematic, fighting with the IRS over whether your ranch is a real business or just a costly hobby can carry a similar level of drama. And unlike the epic, once-in-a-lifetime storyline in Yellowstone, defending a claim that a ranch is a real business against the IRS is much more common.

What Is a Hobby-Loss Under IRC 183?

Generally, businesses are allowed to take a deduction for ordinary and necessary business expenses incurred for the production of income under IRC Sec. 162. But under IRC Sec. 183, individuals and S corporations are ineligible to take a deduction for activities not engaged for profit (i.e., a hobby). If the IRS determines that your activity lacks genuine business purpose, they may label it a hobby. If that occurs, then the IRS will limit a taxpayer’s deduction to the income generated by the hobby.

When a ranching operation consistently reports losses, the IRS may determine that the operation is nothing more than a hobby and saddle the owner under the hobby loss rules in IRC Sec. 183. Understanding how the IRS applies its nine-factor test can help protect legitimate deductions and keep your operation off the audit trail.

Young v. Commissioner

In a recent case, Young v. Commissioner, the Tax Court examined losses sustained from a ranch operated by an Oklahoma couple. In 2013 and 2014, the years at issue, the ranch sustained losses of $257,656  and $305,893, repectively. Similarly, the Court found that over the period between 2008-2022, the ranch sustained $2,953,041 in total losses.

Meanwhile, Ms. Young owned a successful manufacturing company that generated substantial income. The losses from the ranch were used to offset her income from her manufacturing business.

The IRS challenged the deductions, arguing that the ranch was not operated for profit. The Tax Court agreed with the IRS and determined that the ranch was a hobby. The Tax Court came to that conclusion by applying the nine-factor test outlined in Treas. Reg. Sec 1.183-2(b).

Nine Factors Considered by the IRS

No single factor from Treas. Reg. Sec. 1.183-2 is determinative, but when weighed together, they tell a story about the taxpayer’s intentions. The IRS and Tax Court weigh the following factors:

1. How does the taxpayer operate the activity? Does the taxpayer keep accurate books and records and separate business bank accounts?
2. Is the taxpayer an expert or has the taxpayer sought professionals to assist the taxpayer?
3. How much time and effort have been expended by the taxpayer? Is the taxpayer involved in the day-to-day business of the ranch?
4. Does the taxpayer have an expectation that the assets of the ranch would appreciate in value?
5. Has the taxpayer had success in similar or dissimilar activities?
6. What is the history of income or losses by the taxpayer in relation to the activity? Does the venture have profits or only losses?
7. How much profit has been received by the taxpayer? When there is a profit, is it substantial?
8. What is the taxpayer’s financial status? Is the venture funded by the taxpayer’s other sources of income?
9. How much of the use of the property is for personal pleasure or recreational use by the taxpayer?

The Tax Court will look at the totality of the factors in determining if an activity is a hobby.

How Do You Keep the IRS from Labeling Your Ranch as a Hobby?

The distinction between a hobby and a business can be difficult to ascertain, especially early on. It is imperative that individuals be able to substantiate their claims that their ranch is a bona fide business. You can take the following steps to bolster your position:

1. Treat the ranch activities like a business. It is important to have a separate bank account and keep contemporaneous books and records.
2. Develop and follow a business plan to help document how you intend to make a profit. This does not require you to actually make a profit, but it can help show consistent effort to make a profit by the taxpayer.
3. Engage experts to help run the ranch. Hire experienced ranch managers, veterinarians, and other consultants to assist with the day-to-day operations of the ranch.
4. Limit personal and recreational use of the ranch property.
5. Document all of your business activities to help establish profit motives.

You don’t have to operate on the scale of John Dutton, but if the IRS wants a look, you will need more than a scenic view and a few horses to show profit motive. Follow these steps as a start and you will be in a stronger position when the IRS rides into your Yellowstone.

Our Tax Controversy team has decades of experience representing clients before the IRS. Contact us below if you have questions.