The Tax Court in Bartlett, TC Memo 2013-182 found insufficient evidence to prove that the taxpayer met any of the passive activity loss material participation tests for his second business as a bull breeder.
Individuals, trusts, estates, and personal service corporations may not use losses from passive activities to offset non-passive income (salary, dividends, interest, royalties, portfolio gains, and income from active business activities). Passive activities include any business activities in which the taxpayer has an ownership interest but does not materially participate.
Material participation is established by satisfying any one of seven tests. The following three tests are relevant to this case:
- The individual participates in the activity for more than 500 hours during the tax year;
- The individual participates in the activity for more than 100 hours during the tax year, and his participation in the activity for the tax year isn't less than the participation in the activity of any other individual (including individuals who aren't owners of interests in the activity) for the year; and
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.
To satisfy the second test (above), you must participate in an activity for more than 100 hours during the tax year. And, for purposes of that test, your management activities aren't taken into account if:
- another person also receives compensation for management services relating to the activity; or
- another person spends more time on management services relating to the activity than you.
You can prove participation by any reasonable means. This includes, but is not limited to, the identification of services performed over a period of time and the approximate number of hours spent performing the services during such period, based on appointment books, calendars, or narrative summaries. While the regulations permit some flexibility the courts are not required to accept post-event "ballpark guesstimates" or a taxpayer's unverified, undocumented testimony, so keeping good records is very important.
In this recent case, Ben Bartlett had a successful landscaping business in Wyoming. In 2005, he started a bull breeding operation on a ranch in Idaho that was 220 miles from his home.
On both his 2006 and his 2007 federal income tax returns, Bartlett showed losses from the bull breeding activity of over $100,000. In 2006 and 2007, Bartlett employed three of his landscaping business employees to stay at the ranch, as ranch hands, for the entire winter. They worked 40 hours per week during those times. Bartlett also arranged with a farmer, Tuckett, who lived near the ranch, to perform services on the ranch with respect to the cattle, in return for Tuckett being able to graze his horses on the ranch.
Bartlett testified that he spent more than 1,000 hours on the bull breeding activity during 2006 and 2007, including building facilities, planting crops for feed and numerous activities with the cattle. He also testified that he spent 7-10 hours per week researching the bull business and studying live auctions online; and that he spent time while at home in Wyoming in management-related activities for the bull business.
Keeping Good Records Is Key
Bartlett did not maintain a contemporaneous log, a diary, notes, or other records of the work he performed relating to the ranch, whether performed in Wyoming or at the ranch in Idaho. However, he provided two schedules that allegedly detailed the numbers of hours he spent on the bull breeding activity for each tax year. He testified that he created these schedules in 2009 when his returns were audited. He used his credit card statements to determine his work schedule during the tax years at issue. He testified that the schedules did not reflect all of the work he did for the bull breeding business because he didn’t complete the schedules for the entire year. Instead, he stopped once he reached 500 hours of work each year. Mr. Tuckett, Bartlett's son, and one of his landscaping business employees all testified to Bartlett having engaged in activities pertaining to the bull breeding business, but none of them estimated the number of hours that they observed him doing those activities.
Tax Court’s Conclusion
The Tax Court concluded that Bartlett didn't meet any of the three tests discussed above for establishing material participation. Specifically, the Court said that Tuckett, Bartlett's son, and other landscaping business employees were credible witnesses. In fact, the Court went further to say that it had no doubt that Bartlett also spent time in bull breeding activities while he was in Wyoming.
However, the weight of the evidence did not establish that during each of the tax years at issue Bartlett spent 500 hours on the bull breeding activity; or he worked more than Mr. Tuckett, who was at the ranch every day, or the ranch hands, who worked on the ranch 40 hours per week for approximately four months, regardless of whether Bartlett worked more than 100 hours on the bull breeding activity.
In arriving at this conclusion, the Court said that the credit card statements provided no information regarding how many hours Bartlett spent on a given day on the bull breeding activity and that Bartlett's schedules were riddled with contradictions. For example, on several occasions, the credit card statements placed Bartlett in Wyoming or Utah when the schedules of hours he prepared claimed he was working in Idaho. Also, on at least one occasion, Bartlett claimed he spent 28 hours on the bull breeding activity during a 24-hour period. The lack of contemporaneous records was not cured by estimates made years after the fact in writing or by testimony.
The Court said that it would expect persons in Bartlett's situation to have offered into evidence extensive research notes, files, to-do lists, home and mobile phone records, business plans, project descriptions, instructions to employees, and the like, documenting his active involvement in the regular, continuous, and substantial management and day-to-day activities of the bull breeding activity. That documentary evidence was absent. In fact, the evidence showed that Bartlett was at the ranch approximately 58 days in tax year 2006 and approximately 35 days in tax year 2007. Bartlett's sporadic trips to the ranch, coupled with his intense work ethic in the landscape business, did not suggest that he worked on the bull breeding activity in a regular and continuous manner.
The Tax Warrior Perspective
The Passive Activity rules continue to be one of the most complicated and increasing challenged areas of tax law. Many entrepreneurs stumble when it comes to keeping track of their time spent on multiple businesses, mistakenly assuming they can recreate their schedule if need be. This case clearly demonstrates, having proper documentation is crucial to substantiating material participation in a “side business.”
In today’s economic landscape, owning and managing multiple small businesses is becoming more common for entrepreneurs. But, tax implications are rarely taken fully into consideration. If you need help determining the best way to deal with this issue in your businesses, do not hesitate to contact The Tax Warriors®, we’re always prepared to help you with this or any other tax-related matter.