How Long Can You Make A Loss?

[SueBaby]

Have a new client now that has a farm and made a loss for 10 years on it; along with his wife with Mary Kay and she has made a loss for 12. They said they aren't making money and they will never make a profit on them; soooo is this an audit or what?

These are new clients and don't know if I really want a headache over it. What is your feel forever on a loss on these Sch C and Sch F? Don't like what I hear or see now.

[OtisMozzetti]

seeking to earn a profit?

So, don't they have to show that they are seeking to earn a profit, i.e. taxable income instead of losses? There are nine factors, such as changing the method of operation, etc., which suggest the difference between a "hobby" vs. a business. You said that these two have had losses for many, many years.

EA in California

[solomon]

Agree with Otis. Check the nine factors in §1.183-2. In addition, the Economic Substance Doctrine has been codified in §7701(o). There is a notice on this Doctrine as well - Notice 2010-62.

By the way, the IRS anticipates collecting penalties of five billion over the next ten years because of the violation of this Doctrine.

[erchess]

One more bit of advice

If they are losing money on the farm and Mary Kaye, there are only a few possible explanations for how they keep eating.

They could have positive cash flow because the loss is due to depreciation or something else that doesn't affect cash flow.

They could have income from another source that is paying for the losses.

They could be drawing down accumulated savings or investments.

They could be borrowing money.

They could be receiving gifts.

You don't particularly need to post their story here but you need to know what it is and honestly I would require proof.

[gboykin]

To put it in basic terms, are they in it to make a profit? If the answer is no, then no business, hobby. If they say they will never make a profit, then it appears to me that they are not in it to make a profit.

[solomon]

To put it in basic terms, are they in it to make a profit? If the answer is no, then no business, hobby. If they say they will never make a profit, then it appears to me that they are not in it to make a profit.

Profit motive is determined by objective standards - not merely by saying so.

[taxxcpa]

No profit for ten years

Unless they have other income, they must be concealing income. Some people think cash income doesn't count--a nice concept if you can get away with it.

If they continue having losses--and actually do have them--then it is either a hobby or stupidity or some kind of long-range plan that will pay off in the distant future. Maybe they are waiting and hoping someone will drill an oil or gas well and they will get a lot of royalties.

[JohnH]

Tell the wife that she can't deduct cosmetics she uses personally (even though she may regard herself as a walking, talking billboard), cosmetics she gives to relatives as personal gifts (it isn't advertising), and vet bills for her "security cat" (even if she does think it 's deductible because it guards her inventory). That might be enough to wipe out the Mary Kay loss, in spite of what she's heard at seminars.

This client sounds like an audit disaster just waiting to happen, so I'd be inclined to pass on it myself.

[dtlee]

Profit motive is determined by objective standards - not merely by saying so.

I tend to agree with Gary, about having no expectation of profit.

To have an expectation of profit is not enough to prove that an endeavor is a "for profit" activity. However, if the taxpayer clearly does not intend nor expect to make a profit, I would agree that this is enough to disqualify it as a "for profit" activity.

If they were in a business where they could not help but make a profit even though they had no business sense and poor or no organization, their expectation would be that they would continue to make a profit...but that would not make it a "for profit" activity. However, having nothing but losses with no expectation of any change is certainly not an activity that they are in to make money.

[OtisMozzetti]

the RESULT of a business is a profit, derived from satisfying customers

-----------------
...The RESULT of a business is a satisfied customer. - Peter Drucker

Though a successful business must generally produce satisfied customers, another result that is important--for more reasons than satisfying the IRS--is that the business earn profit in the long run.

Many tax service businesses are aware that some clients (customers) cost much more to serve than they produce in revenue, even in the long run or certainly in the short run. Yet those clients, who get much more than they pay, may therefore be very well satisfied customers.

Conceivably, the farm inefficiently grows produce which exquisitely satisfies customers who buy it at an "honor system" drive-by stand where too many of them don't pay enough; and our Mary Kay person thoroughly satisfies her customers while gaining little revenue at very much expense.

[SueBaby]

Unless they have other income, they must be concealing income. Some people think cash income doesn't count--a nice concept if you can get away with it.

If they continue having losses--and actually do have them--then it is either a hobby or stupidity or some kind of long-range plan that will pay off in the distant future. Maybe they are waiting and hoping someone will drill an oil or gas well and they will get a lot of royalties.

The only income I see is from a W2 as a nurse and he has been retired for years as a farmer. Very confuessing and season hasn't started yet.

[Snaggletoof]

Different Risks

Audit risks on Sch C and F are different for many reasons.

The Mary Kay thing is toast. Forget it, except that she may have to report gross income under the "hobby" rules on Line 21.

Farm is different, and I do several who report losses year after year. However, in some years, they have to report recapture of depreciation on 4797 and this exceeds their farm losses and IRS collects money when this happens. Also, land eventually gets sold from time to time, and there are usually whopping gains when this happens. In most cases, the ultimate gain from the sale of a farm can exceed the cumulative effect of all prior losses. Remember, if taxpayer claims losses on farm, he cannot support exclusion via sale of residence for the same property.

Profit "motive" takes on a much different complexion for a farm than for Mary Kay. Many farmers were encouraged by the govt to buy land in days when economic prospects for agricultural products were much brighter. If farmers did not try to raise cattle, hay, or some other product their economic outlook would be much, much worse irrespective of deductibility -- i.e. they have land that they have to do SOMETHING with, or they may lose $20K per year instead of only $7-$8K.

Failure to report income is a common problem, and difficult for IRS to track. However, I do encourage farmers to depreciate their breeding livestock, and if they have 35 cattle and report selling only 8-9 calves for 2-3 years running, I will react and reduce their expenses proportionately.

[SueBaby]

Audit risks on Sch C and F are different for many reasons.

The Mary Kay thing is toast. Forget it, except that she may have to report gross income under the "hobby" rules on Line 21.

Farm is different, and I do several who report losses year after year. However, in some years, they have to report recapture of depreciation on 4797 and this exceeds their farm losses and IRS collects money when this happens. Also, land eventually gets sold from time to time, and there are usually whopping gains when this happens. In most cases, the ultimate gain from the sale of a farm can exceed the cumulative effect of all prior losses. Remember, if taxpayer claims losses on farm, he cannot support exclusion via sale of residence for the same property.

Profit "motive" takes on a much different complexion for a farm than for Mary Kay. Many farmers were encouraged by the govt to buy land in days when economic prospects for agricultural products were much brighter. If farmers did not try to raise cattle, hay, or some other product their economic outlook would be much, much worse irrespective of deductibility -- i.e. they have land that they have to do SOMETHING with, or they may lose $20K per year instead of only $7-$8K.

Failure to report income is a common problem, and difficult for IRS to track. However, I do encourage farmers to depreciate their breeding livestock, and if they have 35 cattle and report selling only 8-9 calves for 2-3 years running, I will react and reduce their expenses proportionately.

He bought a $32,550 tractor to be depreciated and his loss this year is more every year than the last because of him buying alot of equipment or cattle every year; AND he hardly sells anything. One year he did not have income either; didn't buy that year or sell.

[Snaggletoof]

Exactly My Point

Sue, your questions strike to the very heart of what I was trying to illustrate.

What happened to his "old" tractor when he spent $32K for a new one? If he sold it, he most likely has 4797 recapture. If he traded it, then his basis is less than $32K. If he had a year that he didn't sell any cattle, then what happened to the cattle on his books the previous year? If he kept them and kept ALL the calves (unlikely), then you would expect his calf sales the next year to double.

You should be asking these questions and getting straight answers that make sense. If you do this, he will have a hard time avoiding income on Sch F or 4797.

Depreciable equipment for any business and cattle for farmers are items which must be revisited each year for retention or sale. They are not just simply deductions and then they mysteriously "go away."

[SueBaby]

Sue, your questions strike to the very heart of what I was trying to illustrate.

What happened to his "old" tractor when he spent $32K for a new one? If he sold it, he most likely has 4797 recapture. If he traded it, then his basis is less than $32K. If he had a year that he didn't sell any cattle, then what happened to the cattle on his books the previous year? If he kept them and kept ALL the calves (unlikely), then you would expect his calf sales the next year to double.

You should be asking these questions and getting straight answers that make sense. If you do this, he will have a hard time avoiding income on Sch F or 4797.

Depreciable equipment for any business and cattle for farmers are items which must be revisited each year for retention or sale. They are not just simply deductions and then they mysteriously "go away."

Yeah, I really do need more info on their situation here. I have till the first of the year if I even want them as clients; what I have seen here in their boxes doesn't look good and if I do their taxes this year I am afraid it will be a good year for a big audit ---which I avoid.
THANKS TO ALL AND TO ALL A MERRY CHRISTMAS