Tax Court Approves Losses for “Donkey Business”

The IRS often disputes a hobby loss claimed for breeding operations and usually prevails in the Tax Court, a recent case proved otherwise.

Generally, taxpagers can fully deduct expenses from an actual business, but deductible expenses are limited to the amount of income if an activity is treated as a hobby. Furthermore, under the Tax Cuts and Jobs Act (TCJA), clients currently can’t claim any hobby expense deductions, because these expenses must be claimed as miscellaneous expenses. The TCJA suspends the miscellaneous expense deduction for 2018 through 2025. 

To qualify as a business, rather than a hobby, a taxpayer must operate in a business-like fashion and show a true intention of turning a profit. The courts rely on the following nine factors cited in regulations to make this determination:

• The manner in which the taxpayer carries on the activity
• The expertise of the taxpayer or his or her advisers
• The time and effort expended by the taxpayer in carrying on the activity
• The expectation that the assets used in the activity may appreciate in value
• The taxpayer’s success in carrying on other similar or dissimilar activities
• The taxpayer’s history of income or losses with respect to the activity
• The amount of occasional profits, if any, which are earned
• The financial status of the taxpayer
• Any elements indicating personal pleasure or recreation

No single factor controls. The outcome is based on all the relevant facts and circumstances.

Facts of the new case: The taxpayer, a wealthy investment manager residing in Florida, purchased land in New Jersey and established an entity for the purpose of breeding miniature donkeys. The taxpayer wanted to protect the financial future of his daughter, a zoologist, who had relatively modest earnings.
 
The taxpayer expended considerable energy in this activity. He hired experts to assist with breeding and kept detailed records of expenses. Nevertheless, the enterprise showed significant losses for nine consecutive years. The taxpayer still reported millions in annual adjusted income (AGI) during this time on his personal returns.

Based on the evidence presented, the Tax Court concluded that the taxpayer entered into the breeding activity with the dominant hope and intent of turning a profit. Concerned about his daughter’s finances, the taxpayer sought to combine what he did best (making money) with her chief interest (caring for animals) as a way to supplement her limited earnings. 

The entity was attempting to build a foundation that would allow for long-term profitability and did not preclude an honest profit motive. In other words, the Tax Court decided that this was donkey business and not monkey business. As such, the loss deductions were allowed.