Whatley v. Commissioner
T.C. Memo. 2021-11

On January 28, 2021, the Tax Court issued a Memorandum Opinion in the case of Whatley v. Commissioner (T.C. Memo. 2021-11). The issue presented in Whatley v. Commissioner was whether the petitioner’s tree or cattle farm (he can’t seem to decide which) was a trade or business during the years at issue.

A Note on my Favorite Jurist, Judge Holmes

The opinion begins by describing the petitioner as “a proud Auburn alumnus” who made the “tiger’s share of his family’s income from banking.”  Well played sir; well played. When addressing why the cattle farm with no cattle and the tree farm that couldn’t be harvested was audited, Judge Holmes simply notes that “something about this snagged the [IRS’s] attention.” Another classic – “[p]eople don’t go to a mechanic’s banker to fix their cars—they go to a mechanic.”

The Cattle Farm with no Cattle in Whatley v. Commissioner

The petitioner explained that he’d wanted to introduce cattle “from day one.” The petitioner testified that he consulted two cattle experts for advice, but those men managed much larger herds–600 and 1,500 head respectively–than what the petitioner could reasonably expect to put on his property. The petitioner, however, could not recall when this consultation took place or what advice he received. In any event, he didn’t actually have cattle on his property until at least 2008, right after he learned that the IRS was going to audit him. And he explained that many of the activities that he reported as related to cattle were really activities that he undertook in preparation for cattle that would arrive sometime in the future. These included the installation of some fencing and repairs to the barn.

The petitioner’s CPA believed that the LLC that owned the farm was a business, and they reported its principal business activity as a farm and its principal product/service as cattle.  As Judge Holmes so eloquently put it “[a] cattle farm without cattle and a tree farm that doesn’t yet harvest timber is highly likely to produce a bumper crop of losses.” And lose it did.

The Audit Notice

In April 2008, the petitioner was notified that Sheepdog Farms was under audit for tax year 2005. After he received this notice, the petitioner made sure to get a forest-management plan. Cattle then also showed up on the property.

The IRS determined to make adjustments to the petitioner’s joint tax returns, and two of these adjustments led to this litigation–the IRS’s disallowance of the deductions from the LLC and the IRS’s disallowance of a large charitable-contribution deduction for the contribution of a conservation easement that the petitioner and his wife donated along with several other couples, which is the subject of the next case to be reviewed, Sells v. Commissioner, T.C. Memo. 2021-12.

Trade or Business Expense

IRC § 162 allows a deduction for all ordinary and necessary business expenses, but IRC § 183 bars any deduction for an activity that is not engaged in for profit. IRC § 183 can be hugely consequential for a taxpayer. If he doesn’t engage in an activity for profit, then he can deduct IRC § 162 expenses only to the extent of his gross income from the activity. IRC § 183(b)(2).

Relying on Treas. Reg. § 1.183-2(a), although the expectation of profit might not be reasonable, the facts and circumstances must indicate that the taxpayer entered into the activity with the objective of making a profit.  The regulation provides 9 factors to determine whether an activity was engaged in for profit: (1) the manner in which the taxpayer carries on the activity; (2) his own expertise or that of his advisers; (3) the time and effort he expends on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) his success in carrying on similar activities; (6) his history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, from the activity; (8) his financial status; and (9) any elements of personal pleasure or recreation.

Manner in Which the Activity is Conducted

The court begins with the first factor, which looks at how the taxpayer conducts the activity. Treas. Reg. § 1.183-2(b)(1); see McMillan v. Commissioner, T.C. Memo. 2019-108, at *32. A taxpayer who carries on his activity in a businesslike manner and “maintains complete and accurate books and records” is more likely to be profit-minded than one who doesn’t. Treas. Reg. § 1.183-2(b)(1). And if the activity is “carried on in a manner substantially similar to other activities of the same nature which are profitable,” it’s more likely to be a business than a pastime. Id. Abandonment of unprofitable methods likewise shows an intent to improve profitability and may indicate a profit motive. Id.

Complete and accurate books and records reflect a businesslike manner. Treas. Reg. § 1.183-2(b)(1). But the Tax Court does not look at recordkeeping just for its meticulousness, but for whether the taxpayer used his records to help him evaluate how he’s doing, what expenses he might cut, and how he might increase profits. See Golanty v. Commissioner, 72 T.C. 411, 430 (1979), aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981). Judge Holmes observes that keeping so few records prevented the petitioner from seeing how well–or how poorly–he was doing. He didn’t know the value of his timber when he bought the property and did not keep track of its value over time. The absence of good records also prevented Whatley from reporting certain expenses for the LLC, such as insurance. He could not track the LLC’s performance. “This weighs against him.”

A business plan suggests that an activity is conducted in a businesslike manner. Treas. Reg. § 1.183-2(b)(1); see Phillips v. Commissioner, T.C. Memo. 1997-128 (1997). The petitioner had no business plan for the LLC. It wasn’t until July 24, 2008 that he finally got a forest-management plan. This was four years after the he bought the property but less than four months after he learned of the IRS audit. This factor also weighs against him.

If an activity is conducted in the same way as other similar activities that are profitable, it looks more businesslike. Treas. Reg. § 1.183-2(b)(1). There isn’t much in the record about how other tree or cattle farms are operated, but there is some. The Tax Court acknowledged that the IRS didn’t introduce any evidence as to what a small tree farm or cattle farm would look like or that a cattle or tree farm the size of the petitioner’s farm couldn’t be profitable–although we will find that a cattle farm without cattle is not likely to be profitable. The court decided to “be generous and call this factor neutral.”

Changing operating methods, adopting new techniques, or abandoning unprofitable methods in a manner consistent with an intent to improve profitability also indicates that a taxpayer conducted his activity in a businesslike manner.  The facts paint no picture of rapid change to increase profitability, and the farm suffered greater losses as time went on. This factor weighs against him.

Expertise of Taxpayer or Adviser

The regulation next directs the Tax Court to look at whether and how a taxpayer prepared for the activity in question. Treas. Reg. § 1.183-2(b)(2). It specifically directs the court to check for signs that the taxpayer prepared for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with those who are expert therein. Id. “Just getting advice isn’t enough,” begins Judge Holmes, “if he wants to persuade us that he had a profit motive, he’d better follow that advice or tell a plausible story explaining that he’s trying to develop a new or superior technique.” Id. Further, the advice the Tax Court looks for is advice on how to profit from doing the activity in question. Heinbockel v. Commissioner, T.C. Memo. 2013-125, at *25.

Time and Effort Expended on the Activity

The Tax Court next looked at the time and effort a taxpayer spends on the activity. Treas. Reg. § 1.183-2(b)(3). We usually look at three things here—devotion of a significant amount of a taxpayer’s personal time (particularly if he gets no substantial amount of personal pleasure or recreation from it), withdrawal from another occupation to devote most of his energies to the activity, and employment of competent and qualified persons to carry on the activity (which can be important if a taxpayer himself doesn’t spend a lot of time on the activity). Id.

Expectation That Assets May Appreciate

A taxpayer’s expectation that an asset may appreciate in value can show a profit motive. Treas. Reg. § 1.183-2(b)(4). There are some activities in which “an overall profit will result when appreciation in the value of land used in the activity is realized since income from the activity together with the appreciation of land will exceed expenses of operation.” Id. The petitioner’s problem, in Judge Holmes opinion, was that the farm “was so spectacularly unprofitable.”

Success in Carrying on Other Similar Activities

A taxpayer’s success in similar activities in the past can show that his current activity is engaged in for profit. Treas. Reg. § 1.183-2(b)(5). This is because “[a] track record of success in other business ventures may indicate that the taxpayer has the entrepreneurial skills and determination to succeed in subsequent endeavors.” Annuzzi v. Commissioner, T.C. Memo. 2014-233, at *25-*26. What’s needed is some synergy between the prior business and

the current activity. See id. at *26.

History of Income and Loss

The Tax Court must also look to see whether the taxpayer had a history of income or loss with this activity. Treas. Reg. § 1.183-2(b)(6). Lots of businesses lose money at the startup stage, and the regulation recognizes that a history of some losses does not necessarily mean an activity is not engaged in for profit. Id. The regulation also recognizes that there can be losses sustained because of unforeseen circumstances beyond the control of the taxpayer, such as drought or depressed market conditions. Id. The fact of the matter was, the losses were “so sustained and so large” that they were not transitory or unexpected.

Amount of Occasional Profits, if Any

An occasional small profit from an activity generating large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is engaged in for profit. Treas. Reg. § 1.183-2(b)(7). No profits, however, weighed against the petitioner.

Financial Status of the Taxpayer Substantial income from sources other than the activity, particularly if the losses from the activity generate substantial tax benefits, may indicate that the activity is not engaged in for profit. Treas. Reg. § 1.183-2(b)(8). This is especially true if, as here, there are personal or recreational elements involved. Id. “The presence of personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. Treas. Reg. § 1.183-2(b)(9).

That doesn’t mean that a business becomes a hobby just because the taxpayer enjoys it—suffering has never been made a prerequisite to deductibility. Jackson v. Commissioner, 59 T.C. 312, 317 (1972). At the same time, where the possibility for profit is small (given all the other factors) and the possibility for gratification is substantial, it is clear that the latter possibility constitutes the primary motivation for the activity. Dodge v. Commissioner, T.C. Memo. 1998-89, aff’d without published opinion, 188 F.3d 507 (6th Cir. 1999); Burger v. Commissioner, T.C. Memo. 1985-523, aff’d, 809 F.2d 355 (7th Cir. 1987).


Although the Tax Court found a few “neutral” factors, all other factors weighed against the petitioner.  Thus, the cattle farm with no cattle and the tree farm that couldn’t be harvested were not engaged in for profit.

(T.C. Memo. 2021-11) Whatley v. Commissioner

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