The IRS's misguided approach to "recoupment"
For any business, long-term profit potential may hinge, in some measure, on efforts to reduce costs, getting better prices for goods and services, consolidating operations, layoffs, or efforts to promote efficiency.
For many people in the horse or livestock business, the operations have a history of losses, but the expectation is that future operations will be profitable. The IRS will want to see evidence that the taxpayer has taken steps to correct or abandon unprofitable strategies, and to demonstrates steps taken to improve operations.
Often, the IRS will argue that a profit motive ultimately depends on whether the taxpayer expects future earnings and appreciation to be sufficient to recoup accumulated losses of prior years. The IRS will want to see a meaningful plan for recouping losses sustained in prior years.
This seems inherently unfair. Other businesses are not asked to demonstrate a plan to recoup past losses. In some industries past losses have been so great that the companies might never really end up recouping them.
According to Terrence D. Miller, CPA, of Miller and Miller Accountancy Corporation in Fresno, CA:
“In my experience with audits, quite often an auditor will be obsessed with the cumulative losses and they fixate on it. And the losses might not ever be recoupable. Luckily there is a Tax Court case on the subject and usually when you show auditors this case they move on.”
He is referring to Helmick v. Commissioner IRS, T.C. Memo 2009-220, which involved a horse breeding and boarding operation with losses for a period of 17 years. The Tax Court held in favor of the taxpayers, and rejected the IRS “recoupment” argument.
The court said that the IRS “seems to assume that the requisite profit motive as of any given year must involve an expectation that even all past losses will be recouped, so that the activity will have generated a net profit over its entire course. This position distorts the notion of profit motive for purposes of section 183.”
The court cited a hypothetical example: “If a natural disaster caused the death of 90 percent of a rancher’s herd and resulted in a catastrophic loss that could never be recouped, but the rancher thereafter expected to generate an overall prospective profit by breeding and selling the remaining 10 percent of his herd on a foregoing basis, then he could not be said to lack a profit objective after the disaster merely because he would never recoup the prior loss.”
The court pointed out— and this is very important— that the “recoupment” concept is forward looking. That is, the profit objective is shown where the taxpayer expects that the activity will generate an overall profit between the year being audited and the time at which future profits are expected.
To some extent, taxpayers often can explain a poor history of profits due to circumstances beyond their control, including personal issues, casualties, stillborn foals or calves, and the negative effect of the recession on horse sales. The implication is that the activity, in a given year, would have been profitable if these events had not occurred.
Whether an activity producing losses is a business or a hobby is a question that has generated substantial litigation in U.S. Tax Court. If faced with an audit of horse or livestock activities, it can be frustrating when confronted with an IRS auditor who wheels out the “recoupment” argument. Thankfully, there are Tax Court cases, such as that mentioned above, that provide a rational approach in determining whether the taxpayer has a bona fide profit motivation. — John Alan Cohan [John Alan Cohan is a lawyer who has served the livestock, horse and farming industries since l98l. He serves clients in all 50 states and can be reached at: 3l0/278-0203 or via email at firstname.lastname@example.org. His website is www. JohnAlanCohan.com.]