Rancher Had a Profit Motive Despite Million-dollar Losses

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1 In This Issue 1 Rancher Had a Profit Motive Despite Million-dollar Losses 3 Additional Partnership Audit Regulations for Basis and Capital Accounts 4 Safe Harbor for Homes with Deteriorating Concrete Foundations COLA Limits Remain the Same under the Tax Cuts and Jobs Act 6 Tax Court Finds Developer s Properties Held for Investment 7 Certain Exempt Organization Restructuring No Longer Requires New Status Applications 8 The All-Star Tax Series Addresses Tax Reform May 2018 Volume 11 Number 4 Rancher Had a Profit Motive Despite Million-dollar Losses In F.R. Welch (114 TCM 578, Dec. 61,073(M), TC Memo ), the Tax Court held that an economist engaged in his ranching activity for profit under Code Sec. 183 because he carried out the activity in a businesslike manner with a genuine motive to generate a profit, even though the business sustained million-dollar losses during the relevant years. The absence of a written business plan did not negate the taxpayer s profit motive. Significantly, the court treated the taxpayer s cattle raising, hay cultivation, and horse breeding and training activities as a single activity for purposes of satisfying the hobby loss rules. Facts The taxpayer, who had been an economics professor for 40 years and owned a successful consulting business, also owned a multi-operational, 8,700-acre ranch that had a total appraised value over $30 million. On the ranch, the taxpayer engaged in a multitude of activities which included maintaining a veterinary clinic that serviced large and small animals, a horse breeding and training facility, and a trucking operation that hauled his cattle and hay. In addition, the taxpayer raised cattle on the ranch and grew hay as a cash crop and for use in feeding the cattle and horses. The taxpayer spent three days a week at the ranch, employed a full-time ranch manager and subscribed to 20 ranch-related professional journals and publications. The taxpayer s ranch had 25 full- and part-time employees. When needed, the taxpayer realigned his workforce to reflect current needs, or fired employees for nonperformance or inappropriate behavior. The taxpayer advertised the ranch operations and services through its website and Facebook page, and in online horse directories. However, the taxpayer did not have a business plan for the ranch operations and activities. Moreover, the taxpayer s ranching operations were not economically successful, with a history of million-dollar losses. On his tax returns, the taxpayer reported millions of dollars of tax losses relating to operating the ranch. The IRS disallowed the losses claimed by the taxpayer in connection with operating his ranch, because in the view of the IRS, the taxpayer s ranching activities were not engaged in for profit. For tax and legal professionals only. Not for use with the general public.

2 Legal Background The hobby loss rules, which can be found in Code Sec. 183, provide that deductions attributable to activities that are not engaged in for profit are only deductible to the extent of income from it, or to the extent the deductions are allowable regardless of any profit-seeking motive, whichever is larger [Code Sec. 183; Reg ]. A taxpayer s multiple activities may be treated as one activity if the activities are sufficiently interconnected. Generally, the IRS will accept the taxpayer s characterization of multiple activities as either a single activity or separate activities. The taxpayer s characterization will not be accepted, however, when it appears that it is artificial and cannot be reasonably supported by the facts and circumstances of the case. The most important factors that are considered in whether multiple activities may be treated as one activity are the degree of organizational and economic interrelationship of the undertakings, the business purpose served by carrying on the undertakings separately or together, and the similarity of the undertakings [Reg (d)(1)]. The following factors will be considered by the courts in determining whether an activity is engaged in for profit: Whether the activities were conducted at the same place Whether the activities were part of the taxpayer s efforts to find sources of revenue from his land Whether the activities were formed separately Whether one activity benefited from the other Whether the taxpayer used one activity to advertise the other The degree to which the activities shared management The degree to which one caretaker oversaw the assets of both activities Whether the taxpayer used the same accountant for the activities The degree to which the activities shared books and records No single factor or group of factors is determinative [Reg (b)]. Court s Analysis and Conclusion The court first held that the taxpayer s cattle, hay, and horse breeding and training operations conducted on his ranch could be treated as a single activity for purposes of the hobby loss rules because all of the ranch s operations had a high degree of organizational and economic interrelationship as required in Reg (d)(1). The court pointed to these facts: There was one manager on the ranch who oversaw all its operations and employees, and who reported directly to the taxpayer. The hay operation provided feed for the cattle and horses. The cattle operation provided calves for training the ranch s horses. The veterinary clinic and trucking operation provided necessary services to the ranch. The taxpayer maintained books and records for each operation that were combined as the books and records for the ranch. After resolving that issue, the court found further that the taxpayer s ranching activity was a for-profit activity. The court cited the following factors to support this conclusion: The taxpayer carried on the ranch s activity in a businesslike manner. He maintained separate books and records for each of the ranch s operations to determine their incomes and expenses. Even though the taxpayer had no written business plan for the ranch, he made changes in the ranch s activities and operations when he realized that certain operations would not be profitable. The ranch s size and vertical integration indicated that it was operated in a businesslike manner. The taxpayer had the professional expertise necessary to oversee a working ranch. He subscribed to 20 professional journals that discussed ranching, cattle, and horses. He employed competent and qualified managers, trainers and ranch hands to perform necessary services on the ranch and carry on ranch activities in his absence. 2

3 He communicated daily with his ranch managers. His activity was a for-profit activity because he expected the ranch assets and the value of capital improvements made on ranch lands to appreciate. The court concluded that the taxpayer s primary intention in engaging in the activity was to make a profit. Additional Partnership Audit Regulations for Basis and Capital Accounts New proposed regulations under the centralized partnership audit regime address how and when partnerships and their partners adjust tax attributes to account for partnerships payment adjustments. They also provide, among other additions and clarifications to earlier proposed regulations, rules to adjust basis and capital accounts if the partnership adjustment is a change to an item of gain, loss, amortization or depreciation. Background The new centralized partnership audit regime, put into place under the Bipartisan Budget Act of 2015, generally must be applied to audits of partnership returns filed for the 2018 tax year and thereafter. Their implementation largely applies to assessment at the partnership level, leaving the partnership to collect from existing partners, with certain exceptions. In proposed regulations that were issued in June 2017 (NPRM REG ), the IRS acknowledged that more guidance was necessary. In November, the IRS issued proposed regulations on how certain international rules operate within the framework of the new regime (NPRM REG ). In December, the IRS issued proposed regulations on the operation of the push-out rules for partner/partnership liability in tiered structures (NPRM REG ). Imputed Underpayments When a positive partnership adjustment is considered in determining an imputed underpayment, Code Sec does not provide for any item of taxable income to be allocated to partners. Instead, calculations are made at the partnership level, with the partnership paying the liability in the form of an imputed underpayment arising in the year of the audit adjustment. However, if there are no adjustments to outside basis that reflect the partnership adjustments that caused the imputed underpayment, a partner could effectively be taxed twice on the same income (indirectly on the payment of the imputed underpayment, and again on a disposition of the partnership interest or a distribution of cash by the partnership). To prevent effective double taxation or other distortions in these cases, the new proposed regulations provide for adjustment to a partner s basis in its interest, and to certain other tax attributes that depend on basis. No Imputed Underpayment The new proposed regulations provide that an allocation of an item arising from a partnership adjustment that does not result in an imputed underpayment will not be deemed to have substantial economic effect (Prop. Reg (b) (4)(xiii)). It will, nevertheless, be deemed in accordance with the partners interests in the partnership if it is allocated in the manner the item would have been allocated in the reviewed year under the Code Sec. 704 regulations, accounting for the Code Sec. 704 successor rules. Push-out Elections Code Sec. 6226(b) describes how partnership adjustments are taken into account by the reviewed year partners if a partnership makes a push-out election under Code Sec. 6226(a). Under Code Sec. 6226(b)(1), each partner s tax is increased by the aggregate of the adjustment amounts determined under Code Sec. 6226(b)(2). The new proposed regulations provide that the reviewed year partners or affected partners must account for items of income, gain, loss, deduction 3

4 or credit with respect to their share of the partnership adjustments as reflected on statements relating to pushed-out items in the reporting year (Prop. Reg (b)). Partnerships adjust tax attributes affected by a pushed-out item in the reviewed year. Partnerships adjust tax attributes affected by a pushed-out item in the reviewed year. Code Sec. 704(b) An allocation of a pushed-out item does not have substantial economic effect under Code Sec. 704, since the allocation relates to two different tax years (that is, while generally determined with respect to the reviewed year, notional items are considered in the adjustment year). Nevertheless, the proposed regulations provide that the allocation of such an item will be deemed in accordance with the partners interests in the partnership if it is allocated in the adjustment year in the manner the item would have been allocated under the rules of Code Sec. 704(b) in the reviewed year, followed by any subsequent tax years, concluding with the adjustment year (Prop. Reg (b)(4)(xiv)). Burdens of Partnership Underpayments Under the new regulations, persons who were not partners in a reviewed year may be allocated some of a partnership s payment to the IRS. If the reviewed year partner to whom the payment generally would be allocated is no longer present, then the payment instead must be allocated to that partner s successor. Safe Harbor for Homes with Deteriorating Concrete Foundations In Rev. Proc , IRB 559, the IRS provided a casualty loss safe harbor for individuals whose personal residence has a deteriorating concrete foundation containing the mineral pyrrhotite. Facts After Connecticut residents complained about problems associated with their residential concrete foundations, an investigation revealed that deterioration of the foundations was caused by pyrrhotite in the concrete mixture used to pour the foundations. Pyrrhotite is a naturally existing mineral in stone aggregate, which is used to produce concrete. Pyrrhotite oxidizes in the presence of water and oxygen, leading to formation of expansive mineral products and causing concrete to deteriorate prematurely. Affected residents asked the IRS whether they could deduct losses resulting from their deteriorating concrete foundations as casualty losses under Code Sec In addition, they asked when the loss would be deductible and how the amount of the loss would be computed. Legal Background Code Sec. 165(a) generally allows taxpayers to deduct losses sustained during the tax year that are not compensated by insurance or otherwise. For personal-use property, such as a taxpayer s personal residence, Code Sec. 165(c)(3) limits an individual s deduction to losses arising from fire, storm, shipwreck or other casualty, or from theft. A casualty is damage, destruction, or loss of property that results from an identifiable event that is sudden, unexpected and unusual. Damage or loss resulting from progressive deterioration of property through a steadily operating cause is not a casualty loss. Casualty Loss Safe Harbor In Rev. Proc , the IRS provided a safe harbor method that treats certain damage resulting from deteriorating concrete foundations as a casualty loss and provides a formula for determining the amount of the loss. If taxpayers fit the revenue procedure, the IRS will not challenge treatment of damage resulting from a deteriorating concrete foundation as a casualty loss if the loss is determined and reported per the revenue procedure. The safe harbor provided in Rev. Proc is available to individual taxpayers who paid to 4

5 repair damage to their personal residence caused by a deteriorating concrete foundation that contains pyrrhotite if the taxpayer has a written evaluation from a licensed engineer indicating that the foundation was made with defective concrete, and the taxpayer requested and received a reassessment report showing a reduced value of the residential property based on the written evaluation from the engineer and an inspection pursuant to Connecticut Public Act No The safe harbor is also available to a taxpayer whose personal residence is outside Connecticut if the taxpayer has a written evaluation from a licensed engineer indicating that the foundation was made with defective concrete containing pyrrhotite. The amount of a taxpayer s loss resulting from the deteriorating concrete foundation is limited to the taxpayer s adjusted basis in the property. In addition, the amount of the loss may be limited depending on whether the taxpayer has a pending claim for reimbursement of the loss through property insurance, litigation or otherwise. A taxpayer who does not have a pending claim for reimbursement, and who does not intend to pursue reimbursement, may claim as a loss all unreimbursed amounts (subject to the adjusted basis limitation) paid during the year to repair damage caused by the deteriorating concrete foundation. Taxpayers may claim a casualty loss under Rev. Proc by reporting the amount of the loss on Form 4684, Casualties and Thefts, and marking Revenue Procedure at the top of the form. Taxpayers are subject to the $100 limitation imposed by Code Sec. 165(h)(1) and the 10% of AGI limitation imposed by Code Sec. 165(h)(2) COLA Limits Remain the Same under the Tax Cuts and Jobs Act The IRS has announced that retirement plan dollar limitations for 2018 that were previously announced last October in IR and Notice will not change despite the new inflation-adjustment protocol required under the Tax Cuts and Jobs Act. Rounding as specified under the tax code using the new chained CPI method turns out to produce the same results as previously announced for 2018 pension plan and qualified retirement plan limitations, as well as contribution limits and income thresholds for individual retirement accounts and the Saver s Credit. Background Code Sec. 415 provides dollar limitations on benefits and contributions under qualified retirement plans, along with a requirement that the IRS annually adjust these limits to reflect increases in the cost of living. The code provides that various other dollar amounts are to be adjusted at the same time and in the same manner as the dollar limitation of Code Sec. 415(b)(1)(A). The code also provides that several retirement-related amounts are to be adjusted using the cost-of-living adjustment under Code Sec. 1(f)(3). For tax years beginning after Dec. 31, 2017 (Dec. 31, 2018, for individual tax brackets and the standard deduction), the Tax Cuts and Jobs Act requires that calculation of annual inflation adjustments be made by using the Chained Consumer Price Index for All Urban Consumers (C-CPI-U) (Code Sec. 1(f)(3) and (6)). The C-CPI-U is calculated in much the same way as the CPI, but rather than simply accounting for the impact of inflation on the price of goods, it also accounts for consumers diminished capacity to achieve the same standard of living due to the increase in the price of consumer goods. Adjustments The 2018 adjustments provided by the IRS in IR and Notice continue to be applicable. They cover more than 25 categories, including the following: 401(k)/elective deferrals. The limits on elective deferrals for employees who participate in 401(k)s, 403(b)s, certain 457s, and Thrift Savings Plans rise to $18,500 in 2018 after remaining at $18,000 for several years. 5

6 IRA contributions. Eligible individuals can contribute up to $5,500 to an IRA in 2018, the same as for The allowable IRA deduction phase-out at AGI levels will rise, however, as will AGI levels for allowable Roth contributions. Eligible individuals age 50 and above may make catch-up contributions Catch-up contributions. Eligible individuals age 50 and above may make catch-up contributions to IRAs, 401(k)s and other savings arrangements. The catch-up amount for 401(k)s, 457s, 403(b)s, and SEPs remains unchanged for 2018 at $6,000. IRA catch-up remains at the flat $1,000 level specified under Code Sec. 219(b)(5)(B), as it is not subject to annual COLA. Defined contribution plans. The limitation for Code Sec. 415(c)(1)(A) defined contribution plans has increased from $54,000 for 2017 to $55,000 for Defined benefit plans and employee stock ownership plans (ESOPs). The annual benefit limit under a Code Sec. 415(b)(1)(A) defined benefit plan (the maximum amount a plan may pay a participant each year) increases to $220,000 for 2018, up from $215,000 in The amount for determining the maximum ESOP account subject to a five-year distribution period increases from $1,080,000 for 2017 to $1,105,000 for The dollar amount used to determine the lengthening period of the five-year distribution increases to $220,000 for 2018, up from $215,000 in Tax Court Finds Developer s Properties Held for Investment In B.G. Conner (115 TCM 1013, Dec. 61,109(M), TC Memo ), the Tax Court found that the sale of a property resulted in a capital loss because the property was not held in the ordinary course of business. Facts The taxpayer held property for investment. The taxpayer contended that he held all the land for development, which was delayed by the Great Recession. However, development never went beyond the exploratory or formative stages. His expenses for the properties consisted of holding costs, such as mortgage interest and property taxes. The taxpayer did not advertise the properties or list them for sale. He sold only one parcel, to someone making an unsolicited offer, which demonstrated that he held the properties for investment. The taxpayer never subdivided or improved the properties. Each property remained in the same condition as it was on the date of purchase. Further, none of the LLCs incurred any day-to-day operating expenses related to an ongoing development business, only expenses related to holding property for investment. To reduce costs, the taxpayer placed portions of his properties in conservation programs, and bank appraisals treated the land as being held for investment. Court s Analysis and Conclusion The taxpayer did not materially participate in a real-estate activity during the years at issue. He failed to provide the exact number of hours he spent on real-estate activity. The taxpayer did not provide contemporaneous records, such as appointment books, calendars or time logs. In addition, the records he did provide did not contain information on how many hours the taxpayer spent negotiating loans or paying bills. Moreover, one of his employees handled the day-to-day operations of the property, such as dealing with tenants and repairmen. Therefore, without quantification of the employees work, it was impossible to determine the taxpayer s participation. Further, a taxpayer s management activities are not considered if another person receives compensation for management services relating to the activity or spends more time on the management services than the taxpayer. Accordingly, the taxpayer did not materially participate in a real estate activity, and Code Sec. 469 limited his deductible losses. 6

7 Certain Exempt Organization Restructuring No Longer Requires New Status Applications Effective Jan. 1, 2018, the corporate restructuring of a domestic business entity that is classified as a corporation under Reg (b)(1) or (2), and recognized as exempt under Code Sec. 501(a) as an organization described in Code Sec. 501(c), will not be required to file a new application for exemption from tax for the surviving organization so long as these conditions are met: The surviving entity is carrying out the same purposes as the exempt organization had been when it engaged in the restructuring. The organization is in good standing with the state in which it is incorporated or formed (if an unincorporated association) and continues to satisfy the organizational test described in Reg (c)(3)-1(b). Excepted from this updated procedure are corporate restructurings in which the resulting organization is a disregarded entity, limited liability company, partnership or foreign business entity, or the surviving entity obtains a new employer identification number. Any such entity that desires exempt status under Code Sec. 501(a) must follow the regular procedures detailed in Rev. Proc Building a Team of Professionals to Help Provide Solutions for Our Clients At Edward Jones, we believe that when it comes to financial matters, the value of professional advice cannot be overestimated. In fact, in most situations we recommend that clients assemble a team of professionals to provide guidance regarding their financial affairs: an attorney, a tax professional and a financial advisor. We want to work together as a team and offer value for your practice and clients. Using complementary skills and philosophies, we can help save time, money and resources while assisting mutual clients in planning for today s financial and tax challenges. The Connection journal content is provided by Wolters Kluwer and Edward Jones and published by Edward D. Jones & Co., L.P., d/b/a Edward Jones, Manchester Road, St. Louis, MO Opinions and positions stated in this material are those of the authors and do not necessarily represent the opinions or positions of Edward Jones. This publication is for educational and informational purposes only. It is not intended, and should not be construed, as a specific recommendation or legal, tax or investment advice. The information provided is for tax and legal professionals only; it is not for use with the general public. Edward Jones, its financial advisors and its employees cannot provide tax or legal advice; before acting upon any information herein, individuals should consult a qualified tax advisor or attorney regarding their circumstances. Reprinted by Edward Jones with permission from Wolters Kluwer. All rights reserved. 7

8 Connect Online! The All-Star Tax Series Addresses Tax Reform For tax and legal practitioners who want to keep up with the changes brought about by the Tax Cuts and Jobs Act, Edward Jones is pleased to sponsor The All-Star Tax Series. This season, the continuing education broadcasts will assist CPAs, EAs and attorneys in understanding and applying new rules enacted by the recent tax legislation. The programs include timely information and planning strategies to help you to deliver value to your individual and business clients in a quickly evolving tax environment. Viewing options for these convenient courses include participating Edward Jones branch offices, offsite locations or multiple webinar dates. For more information on broadcast topics and how to register, visit or ask your local Edward Jones financial advisor for a complete course catalog. The All-Star Tax Series, produced by All-Star Tax Series, LLC, and sponsored by Edward Jones, is intended to serve solely as an aid in continuing professional education. Opinions and positions stated in All-Star Tax Series programs and materials are those of the presenters and/or authors and do not represent the opinions or positions of Edward Jones. Professional Education Network TM Member SIPC CPA A EXP 30 NOV