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The Hobby-Business Mash-Up

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Fact # 3

Our third case, Carson, presents a very strange fact pattern. Ms. Carson’s mom created a grantor trust and transferred mom’s cattle ranch to it; Mom was trustee. Mom and stepdad were the life beneficiaries of the trust. Ms. Carson and her brother were the remaindermen. During the tax years at issue (2017-2018) Mom and stepdad were living.

Per written agreements, Ms. Carson was obligated to pay the expenses of the ranch. But she was not entitled to any of the income from ranch unless both she and her mom agreed to it. Thus between 2014 and 2019 “[Ms.] Carson made substantial financial contributions to the ranch by paying its expenses. *** The ranch made money mainly by selling cattle. The receipts from the cattle sales were reported on the returns of [Ms.] Carson’s mother.” Oral Transcript at 3. That’s just weird. Normally parents try to assign income to their children, deductions!

It is not clear from the opinion but it appears that the Carsons lived on the ranch. At any rate Judge Morrison says that “the Carson’s two children lived at the ranch helping in the ranch’s business of raising cattle for sale. For this purpose, the children used horses, some of which they also used to compete in cash-prize rodeos. The children also performed manual labor for neighbors of the ranch.”

For the tax years at issue (2017 and 2018) the Carson’s filed a Schedule F, reporting a “livestock” business. However, the only income they reported each year was the cash prizes the kids won in rodeos and the money the kids made from neighbors: some $2,700 in 2017 (all from rodeo prizes) and some $8,000 in 2018 ($6,200 from rodeo prizes). Against that modest income they reported all the expenses Ms. Carson had agreed make: $139,000 in 2017 and $134,000 in in 2018.

This had been the pattern since 2014: “During the six years 2014 to 2019, the Carson’s reported cumulative losses of $502,742 on the schedules F. For each year, these losses not only dwarfed the gross income reported on the schedule F...but they largely offset the Carson’s ordinary income [from] wages.” Yessir, assignment of deductions!

On audit, the IRS disallowed all the Schedule F deductions in excess of the Schedule F income because the IRS Revenue Agent thought that the Carsons had mis-labeled the activity and it should have been reported as a rodeo activity, not a ranching activity. And the rodeo activity was a hobby, not a business. The Carsons petitioned the Tax Court. I cannot tell whether they were represented.


Lesson #3: Hobby + Business = Business?

The basic problem, Judge Morrison decides, is that the IRS mis-analyzed how the Carsons messed up their return. The Carsons' error was mashing up the rodeo activity and ranching activity on the same Schedule. That led the IRS to mis-analyze the return by ignoring the documented arrangement between Ms. Carson. The IRS approach “supposes that the Carsons lost approximately $120,000 per year entering their children in rodeos. *** [That] makes no sense in light of our view that the deductions reported on the Schedules F mainly related to ranching.” Transcript at 8.


Here, unlike our other two cases, the taxpayers kept good records. Transcript at 8. (Ms. Carson “kept meticulous details of the expenses that were deducted on the Schedule F.”). Those records showed most expenses related to the ranching activity and only a “relatively small part” related to the rodeo activity.  Id. Judge Morrison declines to parse the expenses because the IRS “did not challenge the substantiation behind the deductions” id. and thus he was not going to ding Ms. Carson for not bringing records with her to trial.


Bottom Line #3: Don’t try this at home, but once Judge Morrison accepted that the ranching activity was legit, then mashing up the hobby and business was basically harmless error. Sure, the Carsons should have reported the rodeo income on Schedule 1 and not Schedule F. Sure, they should have reported the rodeo expenses on Schedule A (and, of course, for 2018 they would not have been able to deduct any rodeo expenses because of evil §67(g)). The proper reporting position, however, would not have affected their bottom lines very much if at all. The ranching net losses would have still been able to be used to offset the modest rodeo income they had as well as most of their wage income.


Coda: The real issue here—that the IRS just missed—was the assignment of deductions. Judge Morrison notes the weirdness of allocating all the ranching income to Ms. Carson’s mom and allocating all the ranching expenses to Ms. Carson but tells us that a “mismatch of income and deductions is not prohibited under the Code per se, but may be relevant in determining the appropriateness of accounting methods and in determining the appropriate allocation of income and deductions between partners. However, these legal issues are not before the court.”



Are Your Deductions Properly Documented?

January 22, 2025
Recently I came across a professional article about an old subject. Proper documentation. It was just a good reminder of a basic requirement for claiming deductions and expenses for returns. First off, the burden of proof for all deductions and expenses falls on the taxpayer. It is not the IRS job to disprove any deductions and expenses claimed, initially. Once the taxpayer submits proper documentation or evidence for a deduction/expense, then it becomes the IRS’s responsibility to disprove it. When providing proof of documentation, it must be organized such that one can know that it is the related deduction/expense. A tax court case in 2024 involved the taxpayer’s providing photocopies of bills, receipts and handwritten notes, as a group, along with a spreadsheet for one group of the expenses claiming they represented the deductions/expenses on his return. The copies were not grouped by the deductions/expenses or totaled to show the amount claimed. The court called it “the Shoebox Method”. For those of you too young to know what this is, us, old timers, use to see clients bring in a shoebox full of paid bills/receipts in a shoebox and give it to us to process. For some we call it the dashboard method because all the receipts are kept on the dashboard of the taxpayer’s truck until needed. The spreadsheet itself was brought into question as it contained in its listing transactions that no documentation could be found on. Also, transactions were doubled from the original receipt and the credit card receipt. After that, individual transactions were questioned when it appeared that no clients/customers were involved in the meetings. So, the spreadsheet was not credible. So, to summarize, when you want to claim a deduction or expense then you must have a document that supports the claim and then those related documents must be grouped together and totaled to properly substantiate the claim.

Good, Fast, Cheap

January 19, 2025
TRYING TO SAVE MONEY WHEN CHOOSING A CPA COULD BE THE WORST DECISION YOU’VE EVER MADE! The new year is here and now is the time when most, especially if they are business owners, start getting serious about closing out last year and getting ready for meetings with their CPA. It’s also a good reason to ask yourself- did I hire this person to do my taxes because they were cheap or because they were good? There are two things in life you don’t want to scrimp on when hiring a professional; one is your doctor and the other is your CPA and when choosing any professional there are usually three considerations: Good Fast Cheap But here’s the catch: You can usually only have two.

Like your physical health, the stakes are too high to cut corners or gamble when it comes to your business health Choose wrong and simple financial errors could lead to missed opportunities, tax penalties, or cash flow crises that could derail your business. So, this year, ask yourself the following questions. What’s the long-term cost of going fast and cheap and getting this wrong? Am I focused on quick and easy fixes over long term, sustainable solutions? In selecting a CPA partner, how much value do I place on accuracy and expertise? Is it enough to invest in it?
 If you are building something for you and your families future, consider hiring a CPA that will take care of your business now while preparing you for the future. Have a tax or financial planning question? Contact Steven Brewer & Company at (812)-883-6938 or go to https://www.stevenbrewercpa.com/



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